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Stocks Are Excellent Predictors of Recessions


Using analysis of the relationship between stocks and the economic cycle, a rough ride could be in store in the months ahead.


The hot financial topic of discussion at the moment is the likelihood of a U.S. economic recession. Against the background of a deteriorating economic landscape, it is not surprising that more and more commentators have started declaring that a recession is either already underway or just around the corner.

A noteworthy contribution to this discussion has just been offered by Asha Bangalore, economist of Northern Trust. Her analysis deals specifically with the movements of the S&P 500 Index just prior to and during a recession. The leading/lagging properties of the Index, and by how much it changes during a recession, are summarized in the table below.

S&P 500 Index – Peaks and Troughs

Click to enlarge image

* The monthly average value of the S&P 500 Index is used in the analysis.
Source: Asha Bangalore,
Northern Trust – Daily Global Commentary, January 7, 2008.

Two major conclusions taken from Bangalore's research:

(1) The S&P 500 Index is a leading indicator par excellence. Since the 1950s, the Index has nearly always peaked before the peak of a business cycle, with the 1980 business cycle being the only exception. The Index has established a trough prior to the end of a recession without exception.

(2) The median percentage decline of the Index from its peak to trough was 16.9%.

By the close of the market yesterday the S&P 500 Index was down by 9.5% from its peak in October 2007. Although the expectation of a recession has been gaining support, it does not represent a consensus view by a long shot. Using Bangalore's analysis of the historical relationship between stocks and the economic cycle as a guide, a rough ride could be in store in the months ahead.

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