Like the little boy who cried wolf, many on Wall Street have been eager to label the current market pullback as the start of a recession-inducing bear market and the nail in the coffin of this nine-year-old bull run.
But investors shouldn't get too ahead of themselves before the rout actually comes to fruition, said Jeff Kleintop, chief global investment strategist at Charles Schwab Corp. (SCHW) - Get Report . Here's how to spot a recession before it starts, and what Wall Street should keep in mind before the worst case scenario.
So what are the chances of a recession, anyway?
"Over a three or four year time frame? 100%. Over the next six months? Pretty low, contingent on the trade scenario," Kleintop said.
He explained that the yield curve inversion Wall Street so fears will likely be the most useful indicator as to when a traditional bear market begins. Historically, three months after the yield curve inverts, the stock market hits its peak. One year after the yield curve inverts, a recession takes place.
"The beautiful thing about this is the yield curve. It has a perfect 50-year track record. It could be wrong for the first time, but it's been amazing," Kleintop said.
Using the three-month to 10-year yield curve, Kleintop said the bond market can be an eerily accurate predictor. The measure of the difference between interest rates on short-term and long-term government bonds has taken on an increasingly important role on Wall Street in recent months.
"Given where long-term yields are and with where the (Federal Reserve's) path seems to be, we might invert the yield curve a year from now," he said. That would mean a stock market peak next summer, based on the historical performance of the yield curve as an indicator.
At current levels, the yield curve between three-month and 10-year Treasury notes is separated by about 0.90 percentage points. But it's just as important to note what could happen before that gap shrinks and flips as it is to monitor what comes after.
"Everyone knows what happens after the yield curve inverts. Terrible, bad year. But what's less talked about is the year before the yield curve inverts," Kleintop said.
"That's usually pretty strong global economic growth and double-digit returns for the stock market. It's the melt up before the meltdown," he noted.
The last time the yield curve was around as narrow as it is now was just ahead of what was by most measures the worst recession in decades in the U.S. The yield curve inverted in August 2006, and the S&P 500 I:GSPC returned 15.8% that year and 5.5% in 2007.
"You don't want to get out too soon over fear that it's inevitable we're going to have another recession. Yes, it is," Kleintop said. "But I think we could see some solid returns before then."
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