Written by Lance Roberts, Clarity Financial
In the World War II real-time strategy (RTS) game Company of Heroes, released on September 12th, 2006, the engineer squad would sometimes say:
“Join the army they said. It’ll be fun they said.”
Please share this article – Go to very top of page, right hand side, for social media buttons.
Since then, the statement has become a common meme on the internet to espouse the disappointment derived from various actions from doing the laundry to getting a job.
Well, the latest suggested action, which will ultimately lead to investor disappointment, is:
“Ignore the yield curve they said. It’ll be fun they said.”
Last week, Mark Kolanovic of J.P. Morgan stated:
“Historically, equity markets tended to produce some of the strongest returns in the months and quarters following an inversion. Only after [around] 30 months does the S&P 500 return drop below average,”
While the statement is not incorrect, it is advice that will ultimately lead to disappointment.
In 1998, for example, as the bull market was running hot. There was “no recession in sight,” and investors were repeatedly advised to ignore the yield curve because “this time was different.”
After all, at that moment in history, it was perceived to be a “new paradigm.” The internet was changing the world and making old metrics, like earnings, relics of the past. It was even suggested at the time that “investing like Warren Buffett was like driving Dad’s old Pontiac.”
Over the next two years, that advice held true as bullish optimism seemed well founded. It was in early 2000 that Jim Cramer issued his Top 10-Stock Picks for the next decade.
The problem is that no one ever said “sell.”
While it was great that gains were made during the period between the initial yield curve inversion and the peak of the market, all of those gains, plus much more, were wiped out in the ensuing decline. Values in portfolios were returned to where they were roughly a decade earlier by the time the decline was officially over.
Since the majority of mainstream financial advice never suggest selling, investors had no clue that if they had gone to cash in 1998, they saved themselves both a lot of grief and years of losses needing to be recovered.
It was just an anomaly.
That was the belief at the time. Following the “Dot.com” crash, the entire tragic event was considered an anomaly; a once-in-a-100-year event which would not be replicated anytime again soon.
But just 4-years later, in 2006, investors were once again told to ignore the yield curve inversion as it was a “Goldilocks economy” and “sub-prime mortgages were contained.” While many of the individuals who had told you to stay invested leading up to 2000 peak were mostly gone from the industry, a whole new crop of media gurus and advisors once again told investors to “ignore the yield curve.”
For a second time, had investors just sold when the yield curve inverted, the amount of damage that would have avoided more than paid off for the small amount of gains missed as the market cycle peaked.
This quad-panel chart below shows the 4-previous periods where 50% of 10-different yield curves were inverted. I have drawn a horizontal red dashed line from the first point where 50% of the 10-yield curves we track inverted. I have also denoted the point where you should have sold and the subsequent low.
As you can see, in every case, the market did rally a bit after the initial reversion. However, had you reduced your equity-related risk, not only did you bypass a lot of market volatility (which would have led to investor mistakes anyway) but ended up better off than those trying to just ride it out.
That’s just history
Oh, as we noted last week, we just hit the 50% mark of inversions on the 10-spreads we track.
This time is unlikely to be different.
More importantly, with economic growth running at less than 1/2 the rate of the previous two periods, it will take less than half the amount of time for the economy to slip into recession.
While I am not suggesting you sell everything and go to cash today, history is pretty clear that you will likely not miss much if you did.
What Can You Do?
I don’t disagree that the markets could certainly rise from here, in the short-term. I answered this question last week:
“Are we going to hit new highs you think, or is this a setup for the real correction?”
The answer is “yes” to both parts.
The mainstream media’s advice is simply:
“Since you don’t know when a bear market will start, you just have to ride it out.”
This is the problem with the mainstream media and the majority of the financial advice in the world today.
It is not required that you know precisely when one market cycle ends and another begins.
Investing isn’t a competition. It is simply a game of survival over the long-term. While it is critically important we grow wealth while markets are rising, it is NOT a requirement to obtain every last incremental bit of gain there is. Staying too long at the poker table is how you leave broke.
We wrote in early 2018 the bull market had come to its conclusion for a while. That correction process is still intact as shown in the chart below.
There are three important things worth pointing out:
- The top panel is GAAP earnings (what companies REALLY earn) and nominal GDP.
- The black vertical line is when the markets begin to “sniff out” something is not quite right.
- The red bars are when “expectations” are disappointed.
Pay attention to these longer-term trend changes as historically they signify bigger issues with the market.
It is unlikely this time is different. There are too many indicators already suggesting higher rates are impacting interest rate sensitive, and economically important, areas of the economy. The only issue is when investors recognize the obvious and sell in the anticipation of a market decline.
The yield curve is clearly sending a message which shouldn’t be ignored and it is a good bet that “risk-based” investors will likely act sooner rather than later. Of course, it is simply the contraction in liquidity that causes the decline which will eventually exacerbates the economic contraction. Importantly, since recessions are only identified in hindsight when current data is negatively revised in the future, it won’t become “obvious” the yield curve was sending the correct message until far too late to be useful.
While it is unwise to use the “yield curve” as a “market timing” tool, it is just as unwise to completely dismiss the message it is currently sending.
See you next week.
