It’s been nothing short of a banner year for Wall Street and investors. As of the closing bell on Dec. 5, the ageless Dow Jones Industrial Average (DJINDICES: ^DJI), benchmark S&P 500 (SNPINDEX: ^GSPC), and growth-centric Nasdaq Composite (NASDAQINDEX: ^IXIC) have respectively gained 19%, 27%, and 31% year to date.
Wall Street’s two-year bull market has been fueled by a number of catalysts. For instance, the artificial intelligence (AI) revolution may provide a leap forward in growth potential for businesses. Additionally, operating results for Wall Street’s most influential businesses have, for the most part, been better than anticipated.
But the latest catalyst for the stock market is arguably the most eyebrow-raising: President-elect Donald Trump’s November victory.
Trump’s return to the White House for a nonconsecutive second term in January will very likely pave the way for less stringent banking regulations, more merger and acquisition activity, and possibly a 29% reduction in the corporate income tax rate for domestic manufacturers. The proposals laid out by the former (and incoming) president are undeniably investor-friendly.
Unfortunately, history offers an ominous warning for Wall Street and the stock market as Donald Trump prepares to take office in just over six weeks.
President Donald Trump giving remarks at the Pentagon. Image source: Official White House Photo by Tia Dufour.
Republican presidents and recessions go hand in hand
Let me preface the following discussion with an important caveat: There is no such thing as a guaranteed forecasting tool on Wall Street. Although some events, metrics, and predictive data points have an uncanny history of accuracy, there’s no concrete guarantee of anything occurring in the stock market.
With that said, history shows an exceptionally strong correlation between Republican presidents in the White House and U.S. recessions.
Over the last 111 years, there have been 10 Republicans in the Oval Office and nine Democrats. Four of the nine Democrats to hold America’s highest office did not oversee a recession that began under their tenure (key phrase!). This figure makes the logical assumption that President Joe Biden won’t see a recession declared during his final six weeks in office, which would make him the fourth Democratic president to avoid a recession.
On the other end of the spectrum, Republican presidents have overseen 13 recessions since 1913, with every single GOP chief contending with a recession during their tenure. Donald Trump was the latest addition to this lengthy list due to the COVID-19 pandemic-driven recession.
While nothing is guaranteed, every Republican president for more than a century overseeing a recession is a worrisome correlation for Wall Street. Even though stocks and the U.S. economy aren’t tethered at the hip, economic contractions would be expected to adversely impact corporate earnings.
What’s more, a study from Bank of America Global Research found that, between 1927 and March 2023, two-thirds of peak-to-trough drawdowns in the S&P 500 occurred during, not prior to, recessions being declared. In plainer English, stocks perform poorly when recessions occur.
Ominous warnings are mounting for the U.S. economy and stock market
As Donald Trump readies to take office for his second term, he’s going to inherit a challenging set of circumstances. While the Dow Jones, S&P 500, and Nasdaq Composite have all galloped to multiple record-closing highs in the wake of Election Day, ominous warnings for the U.S. economy and Wall Street are beginning to mount.
US M2 Money Supply data by YCharts.
For example, in 2023, U.S. M2 money supply endured its biggest year-over-year decline since the Great Depression.
There have been only four periods prior to last year when M2 money supply fell by at least 2% on a year-over-year basis — 1878, 1893, 1921, and 1931-1933 — and they all correlate with periods of economic depression and double-digit unemployment. Though a depression is highly unlikely in modern times, thanks to the tools the Federal Reserve and federal government have at their disposal, a notable drop in M2 does suggest that consumers may make fewer discretionary purchases, which is an ingredient for a recession.
Another source of concern is the longest yield-curve inversion on record between the three-month Treasury bill and the 10-year Treasury bond.
Normally, the yield curve slopes up and to the right, with yields increasing the longer your money is tied up in an interest-bearing asset. But when investors are worried about the economic outlook, the yield curve can invert, with short-term T-bills sporting higher yields than T-bonds. Although an inverted yield curve doesn’t guarantee a recession will occur, every recession since World War II has been preceded by one.
We’re also witnessing clear-cut red flags from historically flawless valuation measures.
S&P 500 Shiller CAPE Ratio data by YCharts.
The S&P 500’s Shiller price-to-earnings (P/E) ratio, also referred to as the cyclically adjusted P/E ratio (CAPE ratio), ended Dec. 5 at 38.81, well above its average reading of 17.17 when back-tested to January 1871. It also marks the third-highest reading during a continuous bull market.
More importantly, the five previous instances spanning 153 years where the S&P 500’s Shiller P/E topped 30 were eventually followed by declines of 20% to 89% in the S&P 500 and/or Dow Jones Industrial Average.
The famed “Buffett Indicator” is pushing boundaries, too. The valuation tool Warren Buffett praised earlier this century, which divides the market value of all public companies into U.S. gross domestic product, hit a record high of 208% last week. For context, it’s averaged closer to 85% since 1970.
Most signs point to economic and stock market turbulence taking shape at some point during President-elect Trump’s second term.
Image source: Getty Images.
History also shows that patience consistently prevails
But there is a silver lining amid these short-term warnings. Specifically, history is a two-sided coin, and it tends to favor patient investors far more than short-term traders.
Even though Republican presidents and recessions have gone hand-in-hand for more than 110 years, an even stronger historic correlation is the nonlinearity of the economic cycle.
Since World War II came to a conclusion in September 1945, the U.S. has worked its way through a dozen recessions. Of these 12 downturns, nine were resolved in less than a year, while none of the remaining three surpassed 18 months in length. While recessions can undoubtedly be worrisome and lead to emotion-driven moves in the stock market, they’re historically short-lived.
On the other side of the coin, over the last 79 years, there have been two periods of growth that surpassed the 10-year mark. A majority of economic expansions are going to stick around for multiple years, which is why the U.S. economy and corporate earnings grow over long periods.
It’s a similar story for the stock market.
Every year, the analysts at Crestmont Research update a data set that examines the rolling 20-year total returns (including dividends) of the broad-based S&P 500 since 1900. Though the S&P didn’t come into existence until 1923, researchers were able to trace its components to other indexes prior to its inception — thus, the total returns data are back-tested to 1900.
What Crestmont Research found was that all 105 rolling 20-year periods, with end dates ranging from 1919 through 2023, produced a positive total return. In other words, if an investor had, hypothetically, purchased an S&P 500 tracking index at any point since 1900 and held that position for 20 years, they would have generated a profit every single time, regardless of which party controlled the White House during that timeline.
Even if history rhymes, once more, during Donald Trump’s second term, patient investors are well positioned for success.
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Bank of America is an advertising partner of Motley Fool Money. Sean Williams has positions in Bank of America. The Motley Fool has positions in and recommends Bank of America. The Motley Fool has a disclosure policy.