By LARRY SWEDROE
Yield curve conversions.
The combination of worries over both a trade war with China and a yield curve inversion has led to increased volatility in stock, bond, currency and commodity markets alike. For example, as recently as June 15, 2019, the VIX (measure of the volatility of U.S. stocks) was trading at about 12. On August 23, it closed at almost 20—a relative increase of 67 per cent.
In a recent article, I provided my thoughts, and the historical evidence, on the implications of a yield curve inversion on stock prices. The following is a short summary of the key points.
First, prior yield curve inversions resulted from rates rising on shorter-term bonds by more than on longer-term bonds (as the Federal Reserve tightened monetary policy to fight inflation). The recent inversion, however, resulted from a collapse in longer-term rates due to worries over a trade war and the attractiveness of U.S. yields relative to much lower rates that prevail in most of the developed world.
Second, economic growth and bull markets don’t die of old age. They die either because of some exogenous shock (like the oil embargo of 1973, or the events of September 11, 2001) or a tightening of monetary policy by the Federal Reserve. U.S. monetary policy remains easy, with real rates around zero at the short end of the curve, and below zero at the longer end. Fiscal policy is also easy, with the budget deficit for fiscal year 2020 exceeding $1 trillion. In addition, on August 22, 2019, the Conference Board announced that its U.S. Leading Economic Index® increased 0.5 percent in July, following declines of 0.1 percent in both May and June. Ataman Ozyildirim, Senior Director of Economic Research at The Conference Board stated: “While the LEI suggests the US economy will continue to expand in the second half of 2019, it is likely to do so at a moderate pace.”
Third, while inverted curves have predicted all nine U.S. recessions since 1955 (you can observe the relationship in the chart from WealthManagement.com, which shows the yield spread between two-year Treasury notes and 10-year Treasury notes, the traditional measure for inversions), they did not occur for an average of 16 months following the inverted curve, and the setback lasted, peak to trough, for an average of 12 months.
And finally, I summarised a 2018 paper from Dimensional Fund Advisors, “What Does a Yield Curve Inversion Mean for Investors?” covering five major countries and the period beginning in 1985, which found: “It is difficult to predict the timing and direction of equity market moves following a yield curve inversion.”
Most recent research
Professors Eugene Fama and Kenneth French contribute to the literature with their July 2019 study “Inverted Yield Curves and Expected Stock Returns.” They began by noting that much empirical evidence asserts that the slope of the yield curve predicts economic activity—inverted yield curves, with higher yields on short-term government bonds, tend to forecast future recessions. They observed: “Perhaps because of this relation, some investors, fearing that an inverted yield curve predicts low stock returns, reduce their equity exposure when the term spread is negative.” Using monthly stock and government bond data for the U.S. and 11 other major markets, they tested whether that fear is justified.
Their data sample starts in January 1975 with six countries, including the U.S., and grows to 10 countries by 1990, and 12 in 1991. Their sample ends in December 2018. Depending on the data available, they considered up to six term spreads in a country, comparing one-month, one-year and two-year short-term yields with five- and ten-year long-term yields.
Taking the perspective of a U.S. investor, they examined the returns to an active strategy that replaces the stock market with one-month Treasury bills when the U.S. term spread is negative. The active strategies for World and World ex-U.S. combine the dollar-denominated returns from country-specific strategies that follow the same rules as the U.S. strategy, replacing a country’s stock market with U.S. T-bills when its local yield curve is inverted. They compared active and passive strategies for three portfolios—the U.S. market portfolio, the World ex-U.S. portfolio of 11 countries outside the U.S., and the World portfolio of all 12 countries. They value weighted securities in each country and value weighted countries in the global portfolios. Their goal was to assess whether the expected equity premium―the expected return on stock in excess of the bill return―is negative after an inversion.
They describe their active strategy: “A one-year forecast period implies that we want the shape of the yield curve (inverted or not) to predict returns up to a year ahead. To this end, we construct a portfolio every month that makes 12 investments in bills or stocks depending on the yield curve at the end of each of the 12 months of the preceding year. If the yield curve is inverted at the end on month t-1, 1/12th of the portfolio for month t is invested in bills. If the yield curve is inverted at the end on month t-2, another 1/12th of the portfolio for month t is invested in bills. Etc. The portfolio’s total allocations in month t depend on the number of inversions in the prior 12 months. If seven of the term spreads from t-12 to t-1 are negative, 7/12ths of the portfolio is in bills and 5/12ths is in stock in month t.” Thus, an inversion triggers 12 monthly bets with a one-year forecast period and 60 with a five-year forecast period.
They noted that because inversions tend to be persistent, to reduce the likelihood that some signals triggering the active strategy are data errors or other noise, they ignored a negative term spread unless the spreads for the prior two months were also negative. (Increasing the requirement from three consecutive negative spreads to six had no meaningful effect on the results.) For the period 1975-2018, the six U.S. spreads they studied had between six and nine runs with at least three consecutive inverted months. The average length of a run in the U.S. was between 6.3 and 9.2 months. Excluding the first two months of each run because they did not treat their inversions as sell signals, the total number of inverted months varied from 26 (for the U.S. spread between one- and 60-month yields) and 58 (between 12- and 60-month yields). World ex-U.S. and World had about five times as many inverted months (216 and 225 versus 44 for the U.S.), almost twice as many runs (13.0 and 13.3 versus 7.3), and substantially longer runs (19.3 and 19.6 months versus 7.9 months).
Fama and French found that there is “no evidence that inverted yield curves predict stocks will underperform Treasury bills for forecast periods of one, two, three, and five years.” Specifically, they found that in 67 of the 72 strategies examined, following their active rules reduced the investment payoff for the period 1975-2018. “With the diversification of 11 or 12 countries and 60 monthly premiums after each inversion, the average active premiums are more than two standard errors below zero for all six World strategies with five-year forecast periods and for four of six World ex-U.S. strategies. The t-statistics for shorter forecast periods and for five-year U.S strategies are weaker, but the almost uniformly negative average premiums … suggest active strategies that shift away from stock after the term structure is inverted reduce investors’ expected return.” They concluded: “We find no evidence that yield curve inversions can help investors avoid poor stock returns.” They added that this “implies that investors who try to increase their expected return by shifting from stock to bills after inversions just sacrifice the reliably positive unconditional expected equity premium.”
Before concluding, we have one more point to cover.
Differentiating information from value-relevant information
One of the most common mistakes investors make is to confuse information with value-relevant information. It’s important to differentiate the two because if the market (investors in aggregate) knows something (e.g., there is the risk of trade war, or yield curve inversions predict recessions), that information (and the odds of the event occurring, as well as its likely impact) must already be embedded in prices. Thus, it has no value to you. Consider this analogy. Let’s assume you decide not to buy insurance, which would have cost $2,000, against the risks of a hurricane. Later, you learn that a storm is forming that is projected to be a Category 4, and your home is right in the middle of its projected path. You call the insurance company and find out that the policy now costs $20,000.
The knowledge of the increased risk of hurricane damage did you no good, as the market has adjusted its price. The same is true of stock prices, as the market quickly incorporates all new information (such as the president’s latest tweet) and adjusts prices accordingly. Unless you believe you can forecast with greater accuracy than the collective wisdom of the market, it’s too late to act. And the evidence demonstrates there is almost certainly no reason for you to have such a belief. For example, David Bailey, Jonathan Borwein, Amir Salehipour and Marcos López de Prado, authors of the March 2017 paper “Evaluation and Ranking of Market Forecasters,” studied 6,627 market forecasts (specifically for the S&P 500 Index) made by 68 forecasters who employed technical, fundamental and sentiment indicators (the sample period is 1998 through 2012) and found that the distribution of forecasting accuracy by the gurus examined looks very much like the common bell curve—which is what you would expect from random outcomes. While some forecasts turn out to be uncannily accurate, others lead to signiﬁcant losses. Unfortunately, it’s extremely difficult to determine ahead of time which will prove accurate. And if you pay attention, even those who provide the forecasts have admitted the difficulty (though they get paid a lot of money for that).
Here’s what Barton Biggs, who at the time was the director of global strategy at Morgan Stanley, had to say: “God made global strategists so that weathermen would look good.” Keep that in mind the next time you find yourself paying attention to some guru’s latest forecast. You’ll be best served to ignore it.
As I point out in my book Think, Act, and Invest Like Warren Buffett, that’s exactly what Buffett himself does, and what he advises you to do—ignore all forecasts because they tell you nothing about the direction of the market, but a whole lot about the forecaster.
There will always be something for investors to worry about, which is why Buffett warned that once you have ordinary intelligence, success in investing is determined far more by temperament — the ability to ignore the noise of the markets and adhere to your well-thought-out plan that incorporates the risks of negative events. Hopefully, your plan reflects the certainty that negative events, including unpredictable Black Swans, will occur with a high degree of regularity. Getting that right increases your ability to ignore the noise of the market and raises the odds that your head, not your stomach, will be making investment decisions. I’ve yet to meet a stomach that makes good decisions.
Summarising, the strategy most likely to allow you to achieve your financial goals is to develop and adhere to a long-term plan in line with your ability, willingness and need to take risk. By doing so, you will be better able to look past the noise of the market and focus on investing in a systematic way that will help you meet long-term goals.
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of 17 books on investing, including Think, Act, and Invest Like Warren Buffett.
Larry is a regular contributor to TEBI. Here are some of his other recent articles:
Talk of a passive bubble is just hot air
Are IPO stocks worth the risk?
Persistent outperformance remains very elusive
US hedge fund performance underwhelmed again in Q2
Resulting — what it is and why it misleads poker players and investors alike
Dimensional’s David Booth talked about yield curve inversions, among other things, in a recent interview on CNBC. You can watch it here:
David Booth on AK47s and inverted yield curves