A recent conversation with a buddy went like this:
Friend: “I guess now that the yield curve has inverted, I should probably sell my stocks?”
Friend: “Because when the yield curve inverts it means a recession is coming.”
Me: “How so?”
Friend: “Heck, I don’t know, that’s why I’m asking you!”
While I was clearly being obtuse, the point I was making is that while many people read the headlines, few of them may understand the practical application. There has certainly been much talk about the inverted yield curve lately and its predictive abilities regarding recession.
First, the yield curve is simply the relationship between short-term interest rates and long-term interest rates. In a normal environment, shorter rates are lower than longer because a lender wants to be compensated for additional risk of loaning money for a longer period. Additionally, the longer the term of a loan, the more inflation can eat into the returns for the lender. An inverted yield curve occurs when longer interest rates fall below short-term rates, and odd occurrence for sure. In the past, this happened because lenders think economic growth might slow and interest rates may fall even farther. And therein lies its predictive ability of economic weakness.
The problem is that the slight inversion that has occurred may be attributed to central bank manipulation and a flood of foreign investment into our bond market – NOT because lenders are scared. Other countries interest rates are extremely low and even negative in many areas of the world (negative interest rates are an even more bizarre economic tool, the merits of which are a debate for another day). This central bank intervention has distorted the yield curve and, in my opinion, reduces its reliability in predicting recession. In addition, the index of leading economic indicators, a commonly-watch barometer of economic activity, has not turned negative commensurate with a recession – see graph below.
(Click to enlarge graph)
Markets have gyrated wildly in August grappling with conflicting data and political headlines and in doing so, have kept valuations from becoming extreme in my opinion. This can be a good thing as the market lets air out of the tire, perhaps a little along the way rather than all at once. On a valuation basis, the market currently trades slightly above its historical valuation based on underlying earnings and folks, markets generally don’t crash from reasonable valuations. They may go through normal corrections as we saw in December, as well as May and now August, but these are normal market adjustments in my opinion and are not worth trying to outguess. As Warren Buffett once said: “I’ve seen more money lost trying to avoid corrections than ever lost during the corrections themselves”.
Even with the declines in May and August, markets are still largely positive, and a balanced portfolio has served many investors well this year. Interest rates and unemployment are low, housing, autos and construction are strong, the consumer is in decent shape, restaurants are full, and lines are long….if this is what a weak economy looks like, I’ll take it. There’s no way to know exactly how long the current economic expansion will last or how much volatility is in store (August and September have historically been two of the most volatile months in the stock market). But a well-known market strategist that I follow closely recently warned that investor sentiment was still very negative and that it is quite possible they may miss out on potential gains should the economy regain traction at year-end. He stated: “Remember, in a bull market many of the surprises are to the upside, not the downside”. Of course, there is no guarantee of such occurrence and markets still have a way of making people eat crow – which is why there’s never been a better time to maintain a diversified portfolio in my humble opinion.
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