Do We Need to Worry About the Recent Stock Market Sell-Off? Is It Telling Us That a Recession is Looming?

The past week has been volatile for stock markets around the world.  For many investors, this drop feels all too soon after finally recovering from the losses sustained by both stocks and bonds in 2022. There could be more volatility to come with election season looming, current and potential military conflicts abroad, and deepening concern about a U.S. recession. The media will undoubtedly make this feel worse as they seek to capitalize through fearmongering.   

Never underestimate the fact that we’ve been through uncertain and difficult markets before and have always bounced back. But if that’s not enough, here are a few data points that are helpful to keep in mind:  

1.   While US stocks have dropped, they are still positive for the year. While the S&P 500 is down about 10% from its peak in mid-July, it is still positive 9.6% in 2024. The tech-heavy NASDAQ is still up almost 8% YTD.    
2.   Market sell-offs happen almost every year.  In this recent article from Invesco, their Global Market Strategist, Brian Levitt, states: “Since the early 1980s, there has been a greater than 5% drawdown in the S&P 500 Index in every year but two (1995 and 2017).” In fact, 5% pullbacks typically happen ~3 times a year, and corrections of 10% or more happen every 1-2 years.
3.   The stock market has historically recovered relatively quickly after these sell-offs. Levitt’s article also references that the average time to recovery from a 5-10% downturn is three months and the average time to recovery from a 10-20% correction is eight months. Importantly, he does note that if a recession occurs the stock market usually falls by more than 20% and takes longer to recover, typically 1-2 years for more mild recessions.       

Speaking of recession, one of the main drivers of this recent market volatility and the big question on everyone's mind is whether the U.S. economy is headed into one. Some of the closely watched indicators are signaling this is a possibility sooner rather than later.  But as usual, the information is a mixed bag with varying implications.   

For example: Unemployment has been ticking upwards. But as referenced in the chart below from the Federal Reserve Bank of St. Louis, the latest reading wouldn’t be considered high in historical terms. If it continues to increase significantly, that certainly would be problematic. But at this level it could simply be viewed as evidence that the Federal Reserve’s interest rate hikes have been working to cool the economy as hoped.   

Another highly touted recession indicator is an inverted yield curve. In an economy perceived as healthy, investors require less yield on shorter-term debt than on longer-term debt because the short-term is perceived as less risky.  An inverted yield curve occurs when interest rates on short-term treasuries exceed those of long-term treasuries. In other words, investors are demanding greater compensation for shorter-term maturities due to an increase in perceived risk. This article from Barron’s states: “Out of the six recessions since 1980, five were preceded by an inversion of at least 20 days. The sixth—the 2020 recession related to Covid-19—was heralded by a six-day long inversion in August 2019. In other words, recessions can occur well after an inversion has ended.” The current yield curve has been inverted for over 2 years; but lately it has been moving towards a more normal slope and may not be inverted much longer.     

While some indicators are flashing warning signals, it’s not all doom and gloom. Inflation is coming down. Housing inventories are increasing so that it’s less of a frenzied real estate market. There will likely be interest rate cuts soon, which should be a boon to both consumers and corporations. And the U.S. Women’s soccer team just beat Germany to advance to the gold medal match! (Just making sure you’re still with me.)

The moral of the story is that even the most highly-touted economists cannot accurately predict recessions because there are so many data points that can have various interpretations and/or contradictory signals.   

So what should you do to prepare in case we are headed into recession? Ensure you have an emergency fund of 6-24 months of liquid, accessible money (savings, money markets, and/or safer investments such as bonds) depending upon your circumstances. Then, find other things to focus on (GO TEAM USA!) - most importantly your long-term goals.