Sahm Perspective on a Flashing Recession Predictor

Is a recession forming? You might think this question went on hiatus after Q3’s fast GDP growth. But some think October’s jobs report is flashing red, as the Sahm Rule—a purported recession indicator—looks close to triggering. Whether that happens or not, we don’t think an indicator relying on backward-looking data helps you assess where stocks are going.

According to a popular interpretation of the Sahm rule, when the unemployment rate rises half a percentage point (ppt), the economy is in recession. Thus, when the October jobs report showed the unemployment rate rose to 3.9%, up a half-ppt from April’s 3.4%, some outlets warned a downturn may be afoot.^[i] But that is an oversimplification. Per the rule’s creator, former Fed economist Claudia Sahm, “When the three-month moving average of the national unemployment rate is 0.5 percentage point or more above its low over the prior twelve months, we are in the early months of recession.”^[ii]

A Sahm rule indicator built on those criteria was at 0.33 ppt in October, up from September’s 0.20 ppt and the highest since March 2021—so we understand why the metric is getting eyeballs today.^[iii] A quick glance at this indicator’s history seemingly backs up its purported prediction ability. As Exhibit 1 shows, the unemployment rate’s three-month moving average tends to exceed its 12-month low when economic times are tough.

Exhibit 1: The Real-Time Sahm Rule Recession Indicator’s History

Source: Claudia Sahm and St. Louis Federal Reserve, as of 11/6/2023. Real-Time Sahm Rule Recession Indicator, monthly, December 1959 – October 2023. Sahm Recession Indicator reflects three-month moving average of the U-3 unemployment rate relative to its low during the previous 12 months.

However, this isn’t breaking news. The indicator simply smooths out a historic trend: The unemployment rate usually rises in a recession. (Exhibit 2)

Exhibit 2: The Unemployment Rate Often Rises Before Recession Begins

Source: St. Louis Federal Reserve, as of 11/6/2023. U-3 unemployment rate, monthly, December 1959 – October 2023.

We wouldn’t put a whole lot of stock into this historical observation’s forward-looking prowess, either. Sahm herself stresses her indicator “is not a forecast.” Just this week, in a lengthy Financial Times interview, she said, “I spend a lot of time reminding people that the Sahm rule is an empirical regularity. It is not a law of nature.”^[iv] It takes a three-month moving average to smooth out large one-off readings and compares this to its lowest point over the previous 12 months. By its construction, the Sahm rule indicator won’t hit a half-ppt threshold unless the unemployment rate has been rising for a while—it is a lagging confirmation of conditions often associated with recession.

But a higher unemployment rate isn’t always and everywhere a negative, and it happens during expansion at times. For example, a rise in the labor force participation rate may lead to an increase in the unemployment rate—a positive development, in our view, since it means people who weren’t employed and weren’t looking for a job started looking for work. Searching for a job classifies those folks as unemployed, and an encouraging labor market may have drawn them in. Now, this does contribute to the unemployment rate sometimes rising before a recession, when recent hot growth pulls more folks into the workforce than businesses can absorb immediately. But magnitude alone can’t distinguish this from other false positives during an expansion.

Sahm herself has also said her “rule” isn’t a recession predictor. Rather, its original intent was to support policy for sending out stimulus checks automatically. Instead of waiting on Congress to debate and approve sending relief to families, Sahm vouched for an “automatic stabilizer”—i.e., a mechanism built into a government budget that would increase spending or decrease taxes when the economy slows, without any vote from Congress. Sahm advocated sending out cash relief whenever her now-semi-famous unemployment threshold hit. We can debate the benefits and drawbacks of stabilizers, but the upshot: Sahm wasn’t trying to forecast recessions with her rule—and she certainly wasn’t trying to forecast markets.

For those using the indicator as a sign of trouble today, see what Sahm wrote in December 2022: “If the Sahm rule is ever gonna break, it’s next year.”^[v] She reiterated that this week, saying, “Just because it worked in the past to signal early in a recession does not mean that it will necessarily work this time, because all kinds of empirical regularities have broken down in the post-pandemic recovery.”^[vi] In her view, the unemployment rate is unlikely to gallop higher and US consumers are in good shape overall to withstand a potential downturn. Perhaps that holds true. After all, the biggest rise in the unemployment rate recently was July’s rise from 3.5% to 3.8%. But it came with many more people rejoining the labor force, participation still below the prepandemic norm and recovering, and economic indicators pointing positively—suggesting growth and hiring likely continue.

There is another reason the Sahm rule isn’t a recession predictor: Labor data are inherently late-lagging economic indicators. Employment usually follows, rather than leads, economic growth. Look at it from a business owner’s perspective. Hiring is a big investment, so generally speaking, when a downturn begins, companies will cut spending elsewhere (e.g., growth-oriented endeavors and discretionary areas) before reducing their headcount. In our view, labor data confirm what has already happened, and the unemployment rate is an especially fuzzy confirmation. The Sahm rule is arguably more backward-looking, as it is based on the average unemployment rate from the past three months. Think of it this way: Last month’s jobs report tells you about businesses’ and workers’ decisions leading up to October. How would adding two months of older unemployment data and averaging them all out be more revealing about the economy’s future direction?

To reiterate, the Sahm rule is designed to show you that a recession is already underway. It triggers after recession begins. (Exhibit 3). Stocks, meanwhile, typically pre-price recessions.

Exhibit 3: The Sahm Rule Triggers After Recession Begins

Source: St. Louis Federal Reserve and NBER, as of 11/6/2023. Sahm rule trigger threshold is 0.5 percentage point (ppt). *During the 1973 – 1975 recession, the Sahm rule indicator hit 0.5 ppt in March 1974 but fell below that threshold over the next three months. It then crossed 0.5 ppt in July and stayed above that level for the rest of the recession.

In our view, all the attention surrounding this indicator signals the pessimism of disbelief persists. Despite ample evidence the US economy has held up this year, the search for weak spots and signs of a stumble lead headlines. To be clear, we aren’t saying growth is robust. But with weak pockets hogging all the attention, sentiment is pretty poor—setting up a low bar for reality to clear. As challenging as the recent market environment has been, pessimism’s prevalence is reason to be bullish today.