Consumers don’t care for negative surprises. That’s why so many companies affix carefully worded warning labels on everyday goods, ranging from hot coffee cups to hand mixers. And for safety reasons, it’s also why Van Halen buried article 126, also known as the no-brown-M&M’s rider, in their performance contract in the 1980s – the article served as Van Halen’s tripwire: If a concert production crew failed the M&M’s test (a simple snack requirement), they couldn’t be trusted to implement the band’s detailed, precautionary stage requirements.
Informally, the Sahm Rule functions as a warning label for investors who are on the lookout for a recession. Here’s a bit on how it’s calculated and why it’s relevant today:

What Is the Sahm Rule?

The Sahm Rule was developed by economist Claudia Sahm back in 2019 to provide policymakers with a general framework with which to forecast a recession. Its application is quite simple: When the three-month average for the U.S. unemployment rate increases by 0.5% or more from its 12-month low, a recession is looming.

If you’re a believer in the Sahm Rule, you’ll be displeased to know that those conditions were triggered on Aug. 2, when the Labor Department reported an unemployment rate of 4.3%, surpassing the unemployment rate’s 12-month low by 0.53%.

Looking back over recessions over the past 70 years or so, the Sahm Rule has a good track record for lining up closely with recessions, although it’s not always exact. But for the 11 recessions between 1953 and 2020, the Sahm Rule triggered every time within eight months of the recession’s onset. On 10 of those occasions the rule was triggered after the onset of the recession.

To her credit, Claudia Sahm promptly clarified the rule’s current application in a Bloomberg opinion piece on Aug. 7: “The U.S. is not in a recession, despite the indicator bearing my name saying that it is. The Sahm Rule, which was triggered with Friday’s weaker-than-expected jobs report, joins a long list of economic tools skewed by the unusual disruptions of the past four and a half years.” She added, “That said – and I say this with a mixture of humility and concern – the Sahm Rule is still relevant. The risk of a recession is elevated, strengthening the case for the U.S. Federal Reserve to cut interest rates.”

2024 Recession Prognosis

Alex Grassino, head of global macro strategy at Manulife Investment Management, suggests the labor market is balanced now. “We think more about direction of travel than the current level. We’ve come from a clearly overheated environment where the employee/employer leverage dynamic was clearly tilted in favor of the worker; now it’s balanced to leaning slightly towards the employer. To us, the question is how much pronounced this cooling dynamic becomes,” Grassino says.

Still, for many investors, the word “recession” is unequivocally unwelcome. It’s why investor surveys poll for “recession watch,” and read-outs occasionally opine that a plurality of investors may possess a malady dubbed as the “recession obsession.”

Investors’ disdain for recessions do not lack merit, though. Many still recall the Great Recession, when the Dow Jones Industrial Average plummeted more than 50% between Oct. 9, 2007, and March 5, 2009.

For now, Wall Street still assigns a modest probability to a recession in 2024. J.P. Morgan recently put chances at 35% that a recession would emerge by the end of the year. S&P Global estimates there’s a 25% to 30% chance of a recession in the next 12 months. Manulife’s Grassino added, “When the Fed was almost solely committed to fighting inflation, we held a high-conviction view that tighter policy would force the economy into recession. We do still expect the U.S. economy to cool due to the lagged effects of policy tightening, but the balance of risks is a lot more benign than it was at the beginning of the year.”

One key advantage of the Sahm Rule is that it helps policymakers avoid overreacting to sudden data spikes. Multiple data points are required to make an informed decision about unemployment trends and what, if anything, these trends may spell for the economy.

Curious investors could take a cue from the Sahm Rule’s deliberative approach. Another “R” word, restraint, is on full display when the Sahm Rule is applied. Over time, restraint has paid off for many investors during recessions, too: During 16 of the last 31 recessions since the Civil War, the U.S. stock market experienced positive returns, according to data from Russell Investments Research.

Whether the somewhat obscure – but eerily timely – Sahm Rule marks the coming of another recession sometime soon is still up for debate, but given the rule’s historical accuracy, it gives investors a logical reason to at least be on their toes.