Does an Inverted Yield Curve Spell Doom for Investors?
You have probably read the headlines last week about the inverted yield curve and the inevitable doom and gloom of the next economic recession. While we don't take the current news lightly, given that the Dow Jones average finished down 800 points the same day the yield curve inverted, our stance on the matter is pretty simple — business as usual and stick to your plan (assuming you have one).
The question then becomes, "why?" Or quite possibly some of you are even saying #$#% that!
In short, our answer is that investments earmarked for retirement are a long-term strategy and therefore those funds should remain invested in a vehicle that provides higher growth over the long-run. Historically stocks have proven to be one of the best places to achieve this objective. However, we should remind investors that stocks (should) only make up a portion of your overall investment mix.
With that in mind, we feel it is important for the majority of investors to maintain whatever allocation of stocks and bonds that was set forth when the investor originally committed to their investment strategy. More importantly, that investors benefit by staying the course through all economic cycles and only make minor tweaks along the way. The key then is ensuring your allocation (i.e. risk-reward tradeoff) is appropriately aligned with your comfort level and overall objectives. Thereby allowing you to stay true to your plan. This type of mindset works better than “timing the market” because timing when the markets will go up and when they will go down has proven to be an elusive game.
Retirees vs. Accumulators
Taking the importance of proper allocation a step further, let's look at a couple of examples:
Retirees should typically have a higher allocation of cash and bonds because doing so allows the retiree to use those safer investments to supplement their income during a bear market. In turn, the retiree is able to wait until the markets rebound to resume withdrawals from the stock portion of their portfolio. Essentially the higher amount of conservative investments acts as a backup parachute during bad recessionary cycles so that growth assets like stocks can remain invested and be given a chance to recover whenever growth conditions eventually return.
Younger investors, on the other hand, have the luxury of waiting many decades before their investments are needed to generate income during retirement. This expanded time horizon allows the younger investor to allocate more to stocks. In fact, younger investors are at the accumulation stage of life and therefore, declines in the stock market should be seen as a good thing because when the markets go down that younger investor is buying more shares of stock at a relative discount.
The plan (i.e. your investment allocation) should dictate how we invest your money regardless of economic conditions. Impulsively reacting to our emotional response to market volatility is the very reason the average investor consistently underperforms the stock market by nearly 2% every year.
Regardless of what you may think of the rationale outlined above, I have no doubt our skeptical clients out there remain skeptical. When the 24-hour news cycle is constantly feeding us sensationalized storylines for clickbait, it is easy to lose sight of the facts. So what are the facts? Both the good and the bad. Yes, we believe in providing our clients a balanced perspective. Refreshing in today's bipolar world, isn't it.
Facts and Figures
Without further ado, here is what you need to know about the inverted yield curve and other economic buzzwords being discussed during the latest news cycle:
The S&P 500 finished 2018 at 2,485.74 and closed August 12 (same day the yield curve inverted) at 2,840.60 — meaning the stock market is up 14% YTD.
According to Avalon Investment and Advisory’s Bill Stone, when the 10-year Treasury drops below the 2-year rate, stocks have had a positive return on average of 9.2%.
69 economists were polled in January of this year and not one of them predicted the 10-year treasury rates would fall below 2.5% (it was 2% at the time of their prediction, it's now down to 1.7%). Conclusion -- even the smartest experts are really bad at predicting what's going to happen next.
Going back to the 1970s an inverted yield curve has been a reliable indicator of a coming recession. The U.S. Treasury market is different than the stock market in that it has a wealth of similarities and correlations to past economic behavior.
3 recessions have occurred in the U.S. over the last 30 years — the longest period in which there is a significant source of financial and economic data. The concerning part is that each of these periods show a similar pattern of interest rates (see chart above).
The average time it takes for the inverted yield curve to actually lead to a recession is 17 months.
Recessions don't always coincide with a bear market in stocks — 7 of the last 11 recessions either preceded or followed a bear market. The other 36% of the time there was no direct correlation.
According to a study published by Eugene Fama and Ken French, called "Inverted Yield Curve and Expected Stock Returns," there is no evidence that the yield curve predicts stocks will underperform Treasury bills (i.e. cash) for forecast periods of 1, 2, 3, and 5 years. In fact, the yield curve signaling investors to move their money from stocks to cash underperformed staying invested in the world stock market index in 19 out 24 instances. Conclusion — I would rather play the odds (79%) and stay invested in the market.
World economic data is weakening, but the US data remains relatively strong (2.6% GDP growth YTD) and is why many sovereign investors around the globe have shifted money into perceived safe alternatives like US Treasury bonds. Consequently, the heavy demand is driving down our Treasury rates, and more specifically longer-term bonds because foreign investors can lock in at a higher rate. This is especially true relative to what's available from a risk-reward standpoint in their home country. Whenever there exists increased demand for our bonds, the US Treasury is able to lower the interest rate they are required to pay back to their investors — laws of supply and demand.
Time in the market versus timing the market — 5.62% returns versus 2.01% returns. 5.62% is the average annual return an investor received if they stayed fully invested in the stock market from January of 1999 until December of 2018. Compare that to an investor who missed the 10 best days in the stock market and that investor would have earned only 2.01% per year. Conclusion — the worst days in the market are more often followed by some of the best days in the market because that is when traders are most active and volatility is peaking.
The head of the world's largest bond fund says investors shouldn't read too much into the recessionary signal coming from the inverted yield curve. Investors have become overly anxious in the face of strong US economic indications, such as high levels of consumer spending and a tight labor market.
How Should Investors React Going Forward?
Ironically, if enough people perceive a recession is imminent, it could become a self-fulfilling prophecy. However, the numbers by and large still suggest the US economy is on solid footing. It doesn't mean that a global slowdown won't impact us either. It’s very possible the overall slowdown could creep into the US and inflame an economic recession.
Recessions come and go, but predicting precisely when they will occur is a fool's errand. It's why we believe staying the course is the best thing for the majority of investors. Even though doing nothing is usually the hardest thing to do when faced with adversity.At the same time, we at Mellen Money Management understand that stock market volatility makes all of us uncomfortable. To that end, don't hesitate to schedule a time to speak with us to share your concerns.
One of our core missions is to be relied upon as a trusted advisor during the most difficult of times. Part of that might mean we need to be proactive in making changes for a select number of investors, if and only if the positioning of your current investments are allocated well outside of the boundaries of your comfort level. The best way for us to know for certain is to have a more in-depth conversation and decide how to make proper adjustments from there.