Every year or so, we expect the stock market to drop 10-15%, and view this as a healthy exhale or pause within a longer-term secular bull market.  But when the market dips, how do we know the bull market is still alive and the drop is not the beginning of our next sustained bear market?  For the stock market to enter prolonged bear territory, the underlying economy must first enter recession.  Two things happen in advance of a recession: the yield curve flattens and inverts, and the Leading Economic Indicators drop.

The chart below shows the yield curve on U.S. treasury bonds from two different time periods – today, and late 2006.  The vertical axis on the chart shows yield, and the horizontal axis shows maturity.  The green line at the bottom shows yields from today.  An upward-sloping yield curve where short-term rates are lower than long-term rates is referred to as “normal” in shape.  The blue line at the top of the chart shows a curve that has flattened and actually inverted, where short-term rates have risen above long-term rates.  This inverted curve from late 2006 was predictive of the recessionary period that started in 2007.

The Leading Economic index is a basket of data designed to signal the direction of the economy 6-12 months in the future.  In the chart below, the two most recent recessionary periods are represented by the shaded grey bars, and the blue line represents the Leading Economic Index, or LEI’s.  The blue line dips down several months in advance of the recessionary periods, signaling the economic slowdowns.

The next time the market swoons, drop us a line to find out if the yield curve has inverted and/or the LEI’s have dropped so you can respond accordingly to protect your stock portfolio!

Source: U.S. Treasury, © 2016 Pawleys Investment Advisors, LLC. All rights reserved.