Inverted Yield Curves: Buyer Beware!

William Corley  |

Equity, debt, and currency markets appear to be more jittery than is ordinarily the case this time of the year, exacerbated by uncertainty stemming from the midterm elections, global tariff ramifications, and rising rates. The month of October has a foreboding past, comprising half of the ten worst trading days ever, including the infamous Black Mondays in 1929 and 1987 when the Dow Jones Industrial Average (DJIA) suffered losses of 12.82% and 22.61%, respectively. Volatility, a measurement of fear, generally spikes in October. The DJIA volatility during the goblins and witches period has averaged 19% annualized, compared to its all months average of 15%. Americans are 30 days out from the media blitz onslaught preceding the 2018 election. I suspect the dirt, smears, smut, attacks, subjective opinions, propaganda, sensationalism, and extremes from Dramacans and Dramacrats will be less than dignified.

On Tuesday, November 6 (my birthday), 435 House of Representatives and 35 Senate seats are on the line. How will markets react if there is a congressional majority change, split, or continuation as is? U.S. stock markets have been subtly answering this question throughout the year by incrementally inching forward. With a month to go before the electorate casts ballots, is now a good time to pare back risk under the backdrop of all this negativity? Sam Stovall, CFRA Chief Investment Strategist, informs investors that even though October is often full of ghosts and goblins, during midterm election years Wall Street trick-or-treaters have often found more treats than tricks by way of rising stock prices. Historically, Q4 of midterm election years have produced mid-single-digit percentage price gains and increased 80% of the time in the past 70 years. Does this indicate risk-oriented investors are approaching calmer waters and returns are sure to be forthcoming, or will this time be different?

Profit growth is the mother’s milk of increasing asset values. If future earnings estimates meet the 10% earnings per share (EPS) consensus forecast over the next twelve months, stocks are currently overvalued. S&P 500 2019 earnings are projected to hit $178 per share; with the index at 2869, this equates to a 16.1 price-to-earnings multiple, 11% above the 14.5 average over the past decade. Since this bull market began, asset prices have been hoisted from historically low interest rates, aggressive monetary policy, and benign inflation. Each of these ingredients lessens the severity of unwanted volatility, in turn stimulating risk-oriented investor appetites. Taken collectively - tame prices and cheap money make for a potent cocktail that elevated commercial real estate, residential housing, equities, bonds, and global assets to record levels. How long will it last?

Investment pros learn early, or to their imminent peril, that smart money follows the bond market. There is an old Wall Street axiom, “Traders that fight the Fed, are dead,” which means that when the Federal Reserve tightens monetary policy by raising interest rates to prevent the economy from overheating, caution is warranted for intelligent investors.

According to the National Bureau of Economic Research, the U.S. has endured seven recessions over the past half-century. Each of these economic downturns was preceded by one common denominator, an inverted yield curve. A yield curve is a simple line graph displaying interest rates from their shortest to their most extended durations. When the curve inverts, short-term rates are higher than longer-term maturities. Illustrated below, notice the steep upward slope of the orange 2009 line; here, short-term rates yield substantially less than longer-term issues. The ’09 curve represents a growing economy with continued expansion expected. Today, shown by the blue 2018 line, the differential between shorter and longer dated issues has narrowed and flattened significantly. A flattening yield curve portrays an economy transitioning from expansion to slower growth.

Click to enlarge

In the following chart, three-month Treasury bill rates are subtracted from the ten-year Treasury note. When the short term rate (T-bill) exceeds the longer-term rate (T-note), the graph line turns negative. The grayed areas in the graph represent the seven recessions during the past 50 years. The three-month T-bill rate exceeded the T-note rate before each economic contraction. Caveat emptor! How did stocks perform after the yield curve inverted over the course of these seven cyclical downturns?

Click to enlarge

Listed below are the dates that three-month T-bill rates surpassed ten-year T-notes (inversion). The price of the Dow Jones Industrial Average (DJIA) on that inversion date (then), and the DJIA price at the low point of the recession (after).

Click to enlarge

There is an eternal battle going at all times between risk-off and risk-on. Every single person that invests money into financial markets is unique with their inclinations, expectations, risk appetites, and fear and greed barometers. The stock market is a mosaic of everything happening in the world. If history repeats itself, and there is no certainty that it will, the figures in the table above are ominous. The Fed has raised interest rates eight times since 2015 from zero to 2.25% and has forecast more hikes to come. Interest rates are rising because of the robust economy. A strong economy is good for everyone: individuals, businesses, and governments alike. Moderate, sustainable economic output with improved productivity raises standards of living. Growth brings far more good than bad to society. The Fed’s job is to remove the punch bowl from the party as things really liven up by tightening monetary policy. If the Fed overshoots in its aim to foster full employment and maintain price stability, or the economy overheats, and the yield curve inverts, be prepared!

—William Corley

Author of Financial Fitness: The Journey from Wall Street to Badwater 135

Stock price data is provided by IEX Cloud on a 15-minute delayed basis. Chart price data is provided by TradingView on a 15-minute delayed basis.

DISCLOSURE: The opinions made herein are for informational purposes and are not recommendations to any person to buy or sell any securities. The information is deemed to be reliable, but its accuracy and completeness are not guaranteed. 1st Discount Brokerage does not accept any liability for the use of this column. Readers of this column who buy or sell securities based on the information in this column are solely responsible for their actions. Investors/traders are advised to satisfy themselves before making any investment. Nothing published on this site/ article should be considered as investment advice. It's not an offer to buy or sell any security. Readers are solely responsible for their profits or losses.

The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to:

Trending Articles

Bond Yields Have Risen Well Above Stock Dividend Yields. Are They a Buy?
We're at the Tail End of a Classic Video Game Stock Bust
Is Gold Really the Right Place for Your Money?
How Companies Can Succeed in AI Winter: Jeff Kagan

Market Movers

Sponsored Financial Content