Yes, there's been a stock market correction but that doesn't mean our economy is headed for a recession

The latest Bureau of Labor Statistics jobs report released last Friday showed that the economy added 312,000 in December, and it's validation that the current economic expansion is still on track to become the longest expansion in post-war history during President Trump's first term, despite volatility in financial markets.

While many liberal commentators like to depict the recent stock market correction as a death knell for the Trump economy, such commentators should know that financial markets and the broader economy aren't always in lock-step.

As the late Nobel Prize-winning economist Paul Samuelson famously said long ago, "The stock market has forecast nine of the last five recessions." Indeed, that adage applies in the modern age. While the stock market may have sold off close to 20 percent at the end of 2018 – similar to the equity sell-off of 2008 during the Great Recession – there were similar U.S. stock market sell-offs in the summer of 2011 and in late 2015, neither of which were followed by recessions in the U.S.


There are several reasons why the recent contraction in the stock market could be disjointed from the U.S. economy and the Trump administration's economic policies.

First, U.S. stock indices like the S&P 500 largely include multinational companies with substantial profits coming from overseas markets. Recently the International Monetary Fund (IMF) downgraded global economic growth forecasts, which largely have been driven by slowing economies outside the U.S., namely China.


Such concerns, in part, have caused companies like Apple to revise their sales forecasts downwards, which has a direct impact on their stock prices, even though there aren’t immediate implications for U.S. economic growth.

Second, the study of behavioral finance – the intersection of psychology and finance – tells us that individuals are not perfectly rational actors, and that they can often overreact to situations, leading to asset prices that are not based on economic fundamentals.

Just because it's been nearly 10 years since the last recession, doesn't make it any more likely that a recession will occur now compared to, say, five years ago.

At its worst, very poor sentiment and panic can lead to market crashes much like what happened on October 19, 1987 – commonly referred to as "Black Monday" – when the S&P 500 crashed more than 20 percent in a single day. Yet no recession in the U.S. economy immediately followed.

Finally, it's often a fallacy that macroeconomic expansions get "long in the tooth" or "die of old age." Last week at the American Economic Association conference, former Federal Reserve Chair Janet Yellen said she believes expansions "don't die of old age" and that there are generally only two things that can end them: "financial imbalances" or aggressively tight monetary policy set by the Federal Reserve.

In today’s economy, it's hard to see any financial imbalances (like a housing bubble), and hard to argue that the Fed has aggressively tight monetary policy, since it set short-term interest rates between 2.25 and 2.5 percent. (In the early 1980s interest rates nearly reached 20 percent and helped put the U.S. economy in recession.)

Former Fed Chair Ben Bernanke echoed a similar belief at the 2017 SALT Conference, saying that there is a roughly 15 percent probability of a recession happening in any given year, uncorrelated and independent from whether a recession did or did not happen in the previous year.

In other words, just because it's been nearly 10 years since the last recession, doesn't make it any more likely that a recession will occur now compared to, say, five years ago.

This insight also suggests that recessions are very difficult to predict – something which has borne out in practice (very few individuals forecasted the Great Recession of 2008).

With unemployment insurance claims near historic lows, GDP growth close to 3 percent, and the unemployment rate below 4 percent, there seems to be almost no indication from hard macroeconomic data that the U.S. economy is heading for recession.

The stock market may have undergone a correction, but no one should bet that means the economy is about the fail.