Why An Under-the-Radar Recession Warning May Be A Bullish Sign (May 7, 2024)

Michael Kantrowitz of Piper Sandler says his 10% Rule triggered on April unemployment data, setting up new highs for stocks as bond yields fall

By Lisa Beilfuss
May 7, 2024

Many investors and strategists are patiently waiting for a widely followed recession indicator to trigger before preparing for a downturn. The attention may be misplaced. 

As market participants try to decipher if and when an economic downturn will unfold, the Sahm Rule has become a focal point of the recession debate. Developed in 2019 by economist Claudia Sahm, the eponymous indicator triggers when the three-month moving average of the unemployment rate rises by 0.5 percentage points or more relative to its low during the previous 12 months. 

After last week’s jobs report showed that the unemployment rate ticked up to 3.9% in April from 3.8% in March, the Sahm Rule rose to 0.37, its highest reading of the current cycle.

The Sahm rule has already triggered in 20 states, notes Charles Schwab chief investment strategist Liz Ann Sonders. The Sahm Rule is calibrated for the national unemployment rate. But, as Arch Capital Group chief economist Parker Ross says, applying the rule at the state level does a good job of mimicking the national-level rule.

All of that said, those waiting for the Sahm Rule to officially trigger will probably wind up behind the curve. According to Sahm herself, the Sahm Rule isn’t a forecast but a confirmation. Former Federal Reserve economist and recession forecaster Arturo Estrella notes that when the Sahm Rule has risen to the 0.3-0.4% range, it has always breached 0.5%--but only within seven months after the start of recession.  

Here is a potentially better indicator to heed. Michael Kantrowitz, chief investment strategist at Piper Sandler, says the latest unemployment data sparked his simple 10% recession rule, where the year-over-year change in the three-month moving average of unemployed persons is above 10%. 

Kantrowitz’s rule uses unemployed persons, the numerator of the unemployment rate. Sahm has warned that rising labor supply, in part because of immigration, could “break” her rule this cycle. In contrast, the 10% rule is unaffected by labor force participation. 

The 10% rule has never misfired. In the six recessions since 1980, it has triggered an average 3 months after a recession was later determined to have started. Extrapolating with April data suggests a recession may have started in roughly January.

This is where the good news starts. As Kantrowitz puts it, the market’s enemy today is higher inflation. The enemy of higher inflation is higher unemployment. Higher unemployment is thus the market’s friend as it would likely bring down inflation and interest rates, he says. 

Upside surprises this year in both growth and inflation data have significantly reduced Fed rate-cut expectations. Markets remain at the mercy of bond yields, and Kantrowitz notes that every stock-market pullback over the last two years has occurred amid a spike in interest rates. At this point the bond rally of last winter has nearly fully reversed, reigniting concerns around housing, commercial real estate, regional banks, government debt and small companies. A continued rise in rates, or even just interest rates that hold higher for longer, increases the odds that those concerns become more imminent market threats.

Cracks in the labor market are starting to get more mainstream attention. Apart from the April rise in unemployment, consider some additional recent metrics. The latest Job Opening and Labor Turnover report showed that job openings fell to the lowest since February 2021, hiring dropped to the lowest level since the pandemic, and quits declined to the lowest level since January 2021. That is as outplacement firm Challenger, Gray & Christmas said company hiring plans dropped 58% in April from a year earlier, to an 11-year low.  

With investors worried about higher rates, Kantrowitz says it wouldn’t take much in the way of softer data to unlock what he calls a “coiled spring” and see stocks and bonds rally and yields fall.  “Cuts will be here before you know it if the trend continues .. and I think it will. The Fed won’t wait for inflation if this continues,” he says. 

Kantrowitz goes back 60 years to study seven recessions. He says many investors may be missing the current bullish signal because they are focused on what happened during the more recent recessions of 2001 and 2007, where stocks fell alongside lower interest rates. But those downturns are incorrect analogs, he says, because growth–not inflation–was the problem. When inflation is the bigger problem, markets have historically risen as soon as rates fall. 

He predicts that the past few months of both higher rates and commodity prices will lead to softer macro data for May, setting the table for fresh all-time highs in stocks. 

Now for a caveat. Kantrowitz identifies between 3% and 4% as the sweet spot for interest rates. That is to say a moderate decline in rates that is not from a crisis would boost most stocks, especially bond-sensitive areas.  But rates below 3% would suggest economic data and corporate earnings have significantly weakened. Even worse for stocks, he says, are rates below 2.5% because it would imply a very hard landing.

Kantrowitz warns that bears should be wary of expressing their macro views on equities today. That will inevitably change, but probably not before new highs. For now, stock investors may have an underappreciated window for further gains.