This Sahm Rule has predicted almost every US recession – Is this time going to be different?

Why is the “R-word” suddenly making headlines everywhere in the financial news?

Well, it has to do with “The Sahm Rule”…

Over the past few weeks uncertainty and volatility in the markets has increased substantially. A combination of the Japan’s Yen Carry-Trade and the subsequent crash in stocks, bonds, cryptos etc, potential escalations in the wars in the Middle East and Ukraine are mostly to blame. But at the end of July, another concern popped up that has investors, traders and economists worried about what’s coming next for the US (and the globe).

A recession!

So what does Recession and the Sahm Rule have to do with each other?

The Sahm Rule explained…

The “Sahm Rule” is a recession indicator created and named after Claudia Sahm. Claudia is a macroeconomist who worked at the Federal Reserve and the White House Council of Economic Advisers.

Basically, the rule says if the jobless rate, based on a three-month average, is a half percentage point above its lowest point over the previous 12 months, the economy has tipped into a recession.

Last month’s US job report numbers technically met the Sahm rule criteria. The jobless rate in July rose from 4.1% to 4.3%, ticking the three-month average more than a half point above the 3.6% average one year ago.

The calculation is based on rising unemployment typically follows a spike in layoffs. And people who find themselves suddenly out of work often spend less, putting a dent in business profits, which can lead them to lay off more employees.

Interestingly, since 1950, there has only been one false positive (in 1959). But even in that case, the US entered a recession six months later.

Beside 1959, the indicator has correctly flagged 11other recessions.

The question is: Is this time different?

Many financial institutions including JP Morgan think so…

Why?

Well, according to the bank, the US labour market weakening may not be that severe. While, the July jobs report showed a slowdown in the labour market, it was the growth, not layoffs, in the labour force that drove the increase in the unemployment rate. And its layoffs which typically ignite recessions.

Simply put – the rise in unemployment rate is due to increased labour supply, not weakening demand for workers — a stark difference from past recessions.

However, that doesn’t mean the US economy is out of the woods yet. There’s no denying the decrease in jobs reinforces a slowing economy.

But JP Morgan doesn’t think that a recession is imminent. Sahm herself doesn’t think so either.

She also believes her rule may be overstating the labour market’s weakening due to unusual shifts in labour supply caused by the pandemic and immigration.

However, the risk of a substantial weakening or a recession in the next several months is elevated. And I remain cautious.

What’s the next step?

The US Federal Reserve has a mandate to ensure labour market health. So, they’ll be keeping a close eye on recent pickup in unemployment.

If anything, it shows interest rates have been restrictive. And the next logical step for the Fed is a rate cut.

In theory, a rate cut can provide immediate support and breathe life into a slowing US economy and could support asset prices such as stocks.

Will this play out like in the past?

Unfortunately, I don’t have the exact answer. Today, the markets are full of volatility and uncertainty.

Economies are slowing…

Wars are raging on…

And inflation is still relatively high.

All we can do is watch inflation, GDP and employment numbers over the coming months. And prepare accordingly by making sure you have protection such as gold and silver. It’s also worth keeping some cash on the side to scoop up bargains if a recession hits.

In the meanwhile, there are plenty of profit opportunities right here at home, all you need to do is get the next issue of Red Hot Penny Shares out this month to see why.