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The Subtle Signal That the Bull Market Could Soon End

Keith Speights, The Motley Fool

All good things must come to an end. Of course, we don't always know when that end will come. 

There have been predictions for years that the current bull market would soon come to a screeching halt. None of those predictions has come true. In fact, we're still enjoying what has turned out to be the longest bull market in history.

But there's one subtle signal that the bulls might soon run their course. This signal points to the probable onset of an economic recession. As you might expect, recessions have a tendency to stop bull markets in their tracks. This signal has accurately predicted every recession since 1948 -- 11 in total. And for the first time in years, it just indicated that a recession could be on the way.

Man holding toy bear and toy bull in his hands

Image source: Getty Images.

A great predictor

What is this amazingly accurate indicator of a coming recession? The unemployment rate trend. I first came across this idea on the Philosophical Economics blog, whose author has adopted the pseudonym Jesse Livermore, in honor of the 20th-century investor. 

This Livermore conducted a rigorous analysis in search of the perfect recession indicator. He evaluated several potential signals, including real retail sales growth, industrial production growth, real S&P 500 earnings-per-share growth, employment growth, real personal income growth, and housing starts growth. While some of these indicators were promising, none of them compared to the predictive ability of the unemployment rate trend.

Note that it's the unemployment rate trend that's the great predictor of a recession and not the unemployment rate itself. The unemployment rate is a lagging indicator of a recession. In other words, the rate goes up significantly only after a recession is in effect.

But before the unemployment rate moves significantly higher, the unemployment rate trend must change from downward to upward. And that's what Livermore found was a great leading indicator, or predictor, of an economic recession. This change in trend is determined by simply seeing when the latest unemployment rate is higher than the 12-month simple moving average of previous monthly unemployment rates.

So how well does this predictor work? Over the last 70 years, a change in the unemployment rate trend predicted every recession that occurred. In two cases, the recession came immediately after the change in the unemployment rate trend. In other cases, the trend changed several months in advance of the start of a recession.  

The U.S. hasn't experienced an economic recession since the Great Recession of 2008 and 2009. Unemployment rates remain low. However, the U.S. unemployment rate for January, which was reported in early February, moved higher than the 12-month simple moving average of previous monthly unemployment rates.

The subtle signal that has proven to be accurate at predicting the onset of a recession has flashed. And if a recession is indeed on the way, the bull market will soon end.

One drawback

Is there a catch? Yep. While the unemployment rate trend has been uncannily accurate at indicating recessions, it also sometimes provides a false signal. In other words, the trend changes but a recession doesn't occur.

This scenario happened as recently as September 2016. The unemployment rate rose above the 12-month simple moving average for previous unemployment rates for one month. A recession didn't ensue, though, and the bull market kept on trucking.

How often does the unemployment rate trend signal a false alarm? Livermore's analysis found that for a little over 1 out of 4 months over the last 70 years where the unemployment rate was higher than its 12-month simple moving average, the U.S. economy wasn't in a recession. 

What should investors do?

Perhaps the best answer to that question is to know what you shouldn't do.

Don't rush to sell all of your stocks. There are a couple of reasons why you shouldn't. Remember, the unemployment rate trend signal can give false alarms at times. It's also important to understand that the average bear market historically has lasted only 1.4 years, while the average bull market has lasted 9.1 years. 

If you buy stocks that have great business models and you have a long-term perspective, there's no reason to bail out even if a recession is right around the corner. As an example, let's consider Intuitive Surgical (NASDAQ: ISRG), a stock that I own. The company has a razor-and-blades type of business model with its robotic surgical systems and instruments and accessories for those systems.

Like most stocks, Intuitive Surgical's share price would probably fall if a recession began and the bull market ended. However, that wouldn't change the fact that the company has a huge base of customers who would keep on using Intuitive's systems. It wouldn't change the fact that the demographic trend of an aging population should enable Intuitive to keep growing for a long time to come. My view is that Intuitive Surgical is the kind of stock to buy and hold for years, regardless of what happens in the overall market.   

However, if you knew that a recession was likely about to happen, exercising caution before investing a lot of money in stocks would make sense. The recent change in the unemployment rate trend could mean that a recession is on the way and the long bull market is about to finally end.

Because of the past predictive accuracy of this indicator, investors should at least think before investing a lot of money. But you should also take into account the past false alarms for the indicator. The good times just might keep on rolling.  

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Keith Speights owns shares of Intuitive Surgical. The Motley Fool owns shares of and recommends Intuitive Surgical. The Motley Fool has a disclosure policy.