Investing on Wall Street is a tale of two timelines. If you’re a long-term-minded investor, you’re likely well aware that the ageless Dow Jones Industrial Average (DJINDICES: ^DJI), benchmark S&P 500 (SNPINDEX: ^GSPC), and growth-driven Nasdaq Composite (NASDAQINDEX: ^IXIC) rise over long periods. What you might not be aware of is how unpredictable these indexes can be over shorter time frames.
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The past two and a half years have been nothing short of a roller coaster, with the Dow, S&P 500, and Nasdaq screaming to record highs in 2021 and plunging into a bear market last year. It’s left investors to wonder what’s next for Wall Street.
The answer to this question might be found with an all-important economic indicator, which has recently reversed course and tends to fly under the radar of most everyday investors. I’m talking about commercial bank credit.
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A key economic indicator is doing something it hasn’t done for more than a decade
Without getting too far into the weeds, the bread-and-butter formula that allows banks to succeed involves growing their deposits and loans.
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While deposits are important for keeping customers loyal, they’re effectively a liability for banks. In other words, banks pay interest on the money their customers deposit into their checking and/or savings accounts, and they also pay wages and salaries for tellers and customer service representatives. To cover the costs of taking in deposits, banks generate interest income by lending.
Looking back as far as the public data takes us, commercial bank credit has been climbing almost without fail. Since the start of 1973, data from the Board of Governors of the Federal Reserve System shows that commercial bank lending has risen from $567 billion to $17.32 trillion, as of May 31.
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Since U.S. gross domestic product expands over time, it’s expected that we’d see commercial banks increase the aggregate amount of loans outstanding. In fact, seeing outstanding bank credit climb is so common that it’s an economic indicator most investors often overlook or take for granted.
However, something is happening with bank lending that we haven’t witnessed for more than a decade: It’s meaningfully declining.
Over the past 50 years, there have only been four instances where commercial bank credit has dropped by more than 1.5% from an all-time high (1975, 2002, between 2008 and 2010, and currently). Based on the most recent weekly update, bank credit is 1.61% below the all-time high of $17.61 trillion set on March 15, 2023. During the three previous instances where commercial bank credit broke from its seemingly endless uptrend and fell by at least 1.5%, the S&P 500 lost in the neighborhood of 50% of its value.
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Although a 1.61% decline in commercial bank lending might sound harmless, it’s a clear sign that banks are tightening their lending standards. The fact that this tightening coincided with the bank failures of SVB Financial‘s Silicon Valley Bank, Signature Bank, and First Republic Bank may be a warning that banks are concerned about the Fed adjusting liquidity requirements.
It could also be a sign that at least some banks see economic weakness on the horizon and are adjusting their lending standards to prepare for a possible rise in loan delinquencies.
In general, recessions are bad news for stocks. Though recessions are often short lived, the bulk of losses for equities tend to occur during, not prior to, a recession being declared.
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Historically speaking, tightening lending standards may make sense for banks
The argument can certainly be made that banks are being overly cautious. After all, the U.S. economy is expected to expand in the second quarter, the unemployment rate remains well below 4%, and as a whole, earnings for S&P 500 companies came in well ahead of Wall Street’s expectations during the first quarter. Based on select lots of data, it would appear that concerns about an economic downturn are overblown.
However, there are very good reasons for commercial banks to tighten their lending standards based on an assortment of leading indicators.
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For example, the Federal Reserve Bank of New York’s recession probability indicator suggests there’s a good likelihood of a U.S. recession materializing over the coming 12 months. The NY Fed’s recession tool measures the difference in yield (known as the “spread”) between the three-month and 10-year Treasury bonds to determine how likely a recession is for the U.S. economy over the next year.
When the U.S. economy is firing on all cylinders and investors are optimistic, long-dated Treasury notes will have higher yields than those maturing over short periods. Conversely, when investors are concerned about the U.S. economy, the Treasury yield curve can invert. Right now, we’re witnessing the steepest inversion of the yield curve in over 40 years. That’s why the NY Fed’s recession tool suggests a 70.85% chance of a recession over the next 12 months.
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The Conference Board Leading Economic Index (LEI) is another source of caution for commercial banks. The LEI consists of 10 inputs (three financial and seven nonfinancial) and is reported as a six-month annualized growth rate from the comparable period in the previous year. The LEI is designed to anticipate shifts in the economic cycle by about seven months.
While there have been instances over the past 64 years when the LEI has briefly turned negative, the line-in-the-sand level where recessions have previously been a given is a year-over-year drop of more than 4%. Not only is the LEI well past this point, in April it endured its 13th consecutive monthly decline. For context, that’s the third-longest consecutive monthly drop for the LEI, dating back to 1959.
All this means that banks tightening their lending standards seems prudent, especially following the aforementioned failure of a trio of prominent lending institutions.
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This is a dataset you can truly bank on
If you’re a short-term trader, this confluence of data points that includes a decline in commercial bank credit, a historically high probability of a U.S. recession from the NY Fed, and a sizable decline in the LEI isn’t particularly encouraging. But if you’re a patient investor with a five-year-plus horizon, these datasets amount to nothing more than Wall Street noise.
No matter how dire things may seem at any given point in time, the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite have always, eventually, shrugged off downturns and moved to new all-time highs. While the timeline for corrections and bear markets is unpredictable, more than a century of history suggests that patience is handsomely rewarded.
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If investors want a dataset they can truly bank on, look beyond the recent dip in commercial bank lending and focus on the long-term return potential offered by the major indexes, like the S&P 500.
For years, market research company Crestmont Research has been publishing a dataset that examines what a hypothetical investor would have made, including dividends, if they’d purchased an S&P 500 tracking index and held that position for 20 years. Crestmont back-tested its dataset to 1900, which gave it 104 ending years (1919-2022) of return data.
Crestmont’s report showed that all 104 years produced a positive total return, with over half of these rolling 20-year periods leading to an annualized return of at least 9%. Returns of this magnitude absolutely crush all other asset classes on an annualized basis, including oil, gold, bonds, housing, and certificates of deposit (CDs).
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No matter what the U.S. economy throws Wall Street’s way, there hasn’t been a single instance where buying an S&P 500 tracking index and holding for 20 years wasn’t a profitable investment. That’s a dataset long-term investors can truly bank on.
