What does the Sahm Rule Recession Indicator mean for investors?

You may have seen some headlines recently about the Sahm Rule. The Sahm Rule is yet-another way to predict a recession, from Wikipedia:

The Sahm Recession Indicator signals the start of a recession when the three-month moving average of the national unemployment rate (U3) rises by 0.50 percentage points or more relative to its low during the previous 12 months.

Fortunately, you don’t have to get your calculator out, as the Federal Reserve has a real-time chart where it calculates the Sahm Rule. It still only shows the Sahm Rule at 0.33 percentage points, but if the unemployment rate stays at or above the current level of 3.90% for the next 3 months, then we could trigger the rule. 

What happens if a recession hits

Much has already been written about whether this “rule” applies this time around. Claudia Sahm herself has even questioned its reliability in this case. But for the sake of argument, let’s discuss how markets might behave if we did enter a recession in 2024. We’ll use 2008 as an extreme case, although most economists expect any 2024 recession to be far less severe than 2008:

Typical Winners

Bonds: Bonds, especially long-term bonds, would likely be the biggest winner in a recession. Recessions often trigger a Federal Reserve response of lower interest rates and a market response of a “flight to quality.” That leads to a dramatically lower 10-year Treasury yield, which in turn reduces bond yields for all investment grade debt. In 2008, the Vanguard Bond Fund rose by 6% while the total US stock market fell by over 30%.

Could go either way

Tech Stocks: In both 2008 and 2020, tech stocks fell about as much as the overall US stock market. However, in both recessions, tech stocks were the first to bounce back and enjoyed faster growth than other sectors. In today’s context, tech stocks are held down by high interest rates. If interest rates were to fall, that could help tech stocks stay higher or cushion some of their losses. 

Typical Losers

Energy Stocks: Typically, energy stocks suffer the most during a recession. They are highly tied to global consumption patterns, and a recession tends to reduce consumption. However, Energy stocks could be supported in a near-term recession due to ongoing geopolitical conflicts that could reduce supply. 

All US Stocks: Recessions almost always hurt stocks, and typically that pain is shared by most sectors. Depending on the depth of the recession, equities could fall 20% to 50%. 

How to prepare your portfolio

It’s important to ensure that your portfolio is diversified and well-balanced to weather any circumstances. 

In particular, even if you are the most aggressive, long-term advisor, it can be advantageous to keep some bonds in your portfolio. Bonds typically perform well during a recession, giving you “dry powder” to invest in equities when the market hits bottom.