The Chairman of the Federal Reserve just said something very troubling, with potentially immense economic ramifications.
He hinted that the Fed might continue hiking short-term interest rates even if inflation doesn’t move higher. This could mean the Fed is willing to invert the yield curve.
Fortunately, history shows that post-inversion stocks tend to go up for another 12 to 18 months, usually by about 22%. So, avoid the temptation to time the market.
Q3 economic growth is likely to be above 3%, and short to medium-term risks of a recession remain very low (24% or less).
The current economic and earnings fundamentals indicate a recession/bear market is nowhere in sight. Thus, most investors don’t need to start getting defensive yet.
Note that due to reader requests, I’ve decided to break up my weekly portfolio updates into three parts: commentary, economic update, portfolio summary/ stats/watch lists. This is to avoid excessively long articles and maximize the utility to my readers.
This week’s commentary highlights 11 undervalued blue chip high-yield dividend growth stocks that could be just the ticket to achieving your retirement dreams.
Note that I offer these weekly economic updates purely because I believe that investors should always take a holistic “big picture view” of the world. That means knowing the state of the economy and what the short- and medium-term recession risks likely are. However, as I’ll explain later in this article (recession risk section), macroeconomic analysis has historically proven to be a terrible tool for stock market timing (SPY) (DIA) (QQQ). Which is why I only offer these analyses so that readers will likely be able to see a recession coming about a year or so away.
That will hopefully allow you the time to prepare yourself emotionally and financially for the downturn. It will also hopefully allow you to adjust your portfolio’s capital allocation to a more defensive stance, such as with defensive sectors, or potentially greater allocation to bonds (for lower risk-tolerant investors).
Fed Signalling Mission Drift Which Could Inverted Yield Curve But…
Last week, the world’s most important central bankers met in Jackson Hole Wyoming to have their annual summer retreat. Naturally, reporters had many questions for them regarding monetary policy.
Regarding inflation being stable and slightly beneath the Fed’s target of 2.0% core PCE (personal consumption expenditure index excluding volatile food and fuel) Fed Chairman Jerome Powell said “we have seen no clear sign of an acceleration“.
(Source: Bureau Of Economic Analysis)
The core PCE is the government’s best estimate of how much long-term costs of goods and services will rise for Americans factoring in substitution effects (buying cheaper goods to substitute for more expensive ones). The Fed’s official policy is that it wants to keep Core PCE within a symmetrical 2% range. Thus, it and be slightly above or below 2.0% but should average 2.0% over time. And indeed that’s right where core PCE has been in recent months.
The Fed has a dual mandate to maximize employment and maintain stable prices. Theoretically as long as Core PCE is stable at around 2% the Fed should not be hiking rates, regardless of the unemployment or economic growth rate. The trouble is that according to Powell “my colleagues and I believe that this gradual process of normalization remains appropriate.” What does “gradual normalization” mean? That’s economist talks for as many as one rate hike per quarter.
Effective Federal Funds Rate data by YCharts
2004 to 2006 was the last time the Fed undertook a “gradual” normalization process, hiking 25 basis points each quarter, 17 straight times. This is likely what contributed to the popping of the subprime bubble and played a major role in triggering the Financial Crisis. If the Fed doesn’t see inflation going up anytime soon, then why keep hiking?
“Whatever the cause, in the run-up to the past two recessions, destabilizing excesses appeared mainly in financial markets rather than in inflation…Thus, risk management suggests looking beyond inflation for signs of excesses.” – Jerome Powell
Powell also pledged the Fed would “do whatever it takes” to avoid another financial crisis. Here’s the problem. The Fed seems to be thinking that even if inflation remains stable, then a strong economy might still “overheat” because financial firms will start making dangerous loans. Thus far, we’re not seeing this from major financial companies like strategically important banks. Yes some smaller companies are making more subprime auto loans and mortgage loans, but these are not likely to crash the financial market. Not when big banks are still growing their loan books modestly and maintaining good underwriting standards (car makers are doing the same). As a result, charge-off rates remain low and even continue to decline.
On the other hand, the Fed continuing to hike does threaten to slow the economy and invert the yield curve (more on this in a moment). Since the 1960s, 90% of the time the yield curve has inverted a recession has followed soon afterward. Now, it should be noted that Powell isn’t dangerously reckless and has said “if things deteriorate, there is no reason why we won’t stop.”
The trouble is that by the time economic data shows growth is slowing significantly it might be too late to avoid recession. Here’s what James Bullard, President of the St. Louis Fed (non voting FOMC member) told reporters at Jackson Hole:
“There is no reason to challenge the yield curve at this time…Inflation is low, it is stable, it is barely up to target. We don’t need to be preemptive on the yield curve…I would rather not be calling rates accommodative right now…I think we are at neutral or very close to neutral interest rates.” – James Bullard
What Bullard means by “neutral rate” is a theoretical Fed Fund rate (currently 1.75% to 2%) that neither slows nor accelerates the economy. The Fed’s consensus estimate of this neutral rate is about 2.75%, which would mean that at least three more rate hikes are likely coming. Bullard (and I) think the neutral rate is probably close to where we are today. Thus, as long as core PCE remains at current levels the Fed should avoid hiking to battle imaginary economic demons. Demons that the data shows don’t currently exist.
Now, one of the reasons that Powell might be willing to keep hiking is because some at the Fed think that QE (Fed buying 10 year treasury bonds by the trillions) pushed the yield curve down artificially. A 2017 study by the Fed estimates that the yield curve might be 1% lower than it would have been without QE. Thus, it’s possible that some of the FOMC members (the ones voting to keep hiking) believe the “adjusted yield curve” is actually 1.19% right now, far from signalling danger. Of course, as with “adjusted earnings”, you need to be very careful that the adjustments are actually appropriate. I personally won’t be gambling that “this time is different” and will assume any inversion means a 90% probability of recession within 24 months. Thus, my recession prep protocol, outlined in the conclusion.
Ultimately, the bond market is disagreeing with the Fed and indicating it thinks US economic growth (and thus inflation) will not be accelerating in 2019 and beyond. This is the reason the yield curve is now at the lowest level since 2007 and getting dangerously close to inverting. So, does that mean the Fed is about to make yet another major policy mistake and potentially hike us into a recession (as it did the last two times)? Very possibly. So, that means you should sell all your stocks now and go to cash to avoid the bear market right? Absolutely not.
…Even If An Inversion Is Coming Soon, A Bear Market Probably Isn’t
I can’t stress this enough. Yield curve analysis, like all macro economic analysis, is not a precise science to be used for market timing purposes. It’s merely historical analysis that allows you to estimate, based on probabilities, roughly when a recession will come if the yield curve inverts. If you assume that an inversion means doom for stocks, then you are likely to regret it.
This is because in the modern era, post-inversion stocks didn’t peak until many months later. In fact, the median length of time between an inversion and the S&P 500 peaking was 19.3 months. And during that time, the median market return was 22.3%.
So, does that mean that post inversion you should wait 19 months, lock in those 22% extra gains and then go to cash to wait for the crash? Again no. Market timing isn’t just hard, it’s all but impossible.
That’s because even if you call the market top and bottom correctly, you’ll still end up losing money in the end. This is because nearly all of the market’s long-term total returns are generated by just a fraction (less than 1%) of its best days. Miss the market’s best 30 days over the last 20 years and instead of making 7.2% CAGR total returns as the S&P 500 did, you’d actually have lost money. Miss the best 50 days (best 1% of market days) and you’d have lost 60% over the past two decades.
Unfortunately, the market’s best days tend to come within 2 weeks of its worst days. Thus, to successfully market time means becoming a day trader during times of peak market volatility. But since 92% of day traders lose money, and even fewer consistently make a profit, it’s nearly a certainty that attempting to avoid a bear market is going to cost you a fortune in the long term.
Current Economic Growth Projections
It’s important to remember that the Atlanta Fed’s economic model is usually overly bullish and very volatile. That’s due to how it weights its leading indicators and economic reports, with a very heavy emphasis on volatile ISM indices. However, it appears to be stabilizing at a very robust 4+% which if accurate would mean America is likely to achieve its first full year of 3+% growth since 2005. More important to note is that the analyst consensus is steadily rising and is currently at 3.2% GDP growth for Q3.
The New York Fed’s real-time GDP tracking model is far more conservatively weighted and thus tends to be more stable. This is the most bearish economic model I’ve seen, estimating just 2% GDP growth for Q3. That’s due to the buildup of inventories for durable goods. However, the Atlanta Fed’s interpretation of the same data resulted in it raising its economic forecast. That’s because excluding volatile auto and plane orders, durable good orders have risen for six straight months, indicating robust economic growth.
The bottom line is the rate of economic growth continues to be stronger, but not so strong as to trigger “overheating” and rising inflation. This means the US economy remains in the Goldilocks zone that is needed to keep the expansion (and bull market) rolling for several more years.
Recession Risk: Very Low
I use five key meta analyses to track the health of the economy. That includes those which have historically proven to be good predictors of recessions:
- The 2/10 yield curve;
- The Base Line and Rate of Change or BaR economic graph;
- Jeff Miller’s meta analysis of leading economic indicators;
- The St. Louis Fed’s smoothed-out recession risk indicator; and
- The New York and Atlanta Fed’s real-time GDP growth trackers.
(Source: Business Insider)
The yield curve has proven the single-most accurate predictor of recessions over the past 80 years. Specifically, when the curve inverts, or goes below 0 (because short-term rates rise above long-term rates), then a recession becomes highly likely. It usually begins within 12-18 months.
|Yield Curve Inversion Date||Recession Start Date||Months To Recession Once Curve Inverts|
|August 1978||January 1980||17|
|September 1980||July 1981||10|
|December 1988||July 1990||19|
|February 2000||March 2001||13|
|December 2005||December 2007||24|
(Source: St. Louis Federal Reserve, Ben Carlson)
According to a March 2018 report from the San Francisco Fed, an inverted yield curve has “correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession.” In other words, if the yield curve goes negative, there is probably a 90% chance of a recession starting within the next 17 months or so.
Unfortunately, investors hoping to use the yield curve to time market tops are out of luck. While a yield curve inversion is very accurate at predicting recessions with long lead times, its track record on predicting bear markets is far less impressive.
2/10 Yield Curve Inversion Vs. Bear Market Starts
(Source: Wealth Of Common Sense)
The lag time between market tops and yield curve inversions is all over the map, ranging from just 2 months in 2000 to nearly 2 years in 2005.
And if we go back to 1956 (using the 1/10 yield curve), we can also see that yield curve inversions are largely useless for timing bear market starts. In fact, on three occasions, the forward-looking market has actually peaked before the curve inverted. This means that the yield curve should not be used as a market timing mechanism but rather purely as a good recession risk indicator.
Current 2/10 Yield Curve: 0.19% (down from 0.26% last week)
The yield curve is at its lowest level in 11 years. This is due to the bond market being confident the Fed will keep hiking short-term rates but being bearish on the prospects of long-term accelerating economic growth and inflation.
However, typically, the 7/10 yield curve inverts first (by 6 to 28 days). It currently remains stable at 0.04% (it’s naturally lower than 2/10), and so, there is no indication that an inversion is imminent. I don’t expect the 2/10 curve to invert before the 7/10 so we should have a few weeks warning before a 2/10 inversion officially starts the recession countdown.
But it’s important to remember that you shouldn’t fear a flat yield curve as a sign of poor short to medium-term stock performance.
During the strongest bond market in US history (tech boom), the yield curve was as low or even lower than it is now. Of course, that was also an epic bubble, but the point is that a flat but positive yield curve is not a sign of poor returns ahead.
Average Monthly Stock Market Returns By 2/10 Yield Curve Slope (Since 1976)
In fact, over the past 42 years, the period when monthly stock returns were at their highest and volatility was at its lowest was when the yield curve was flat but positive. This means that we’re likely in the sweet spot right now, and investors should avoid using fears of yield curve inversion as a reason for market timing.
Remember that the yield curve is a totally binary indicator.
- positive = very low recession risk (carry on with long-term investing plans)
- negative = 90% chance recession is coming within 6 to 24 months (most likely 18 months) – consider getting more defensive
The second economic indicator I watch is Economic PI’s baseline and rate of change, or BaR economic analysis grid. This is another meta analysis incorporating 19 leading indicators that track every aspect of the US economy. That includes the yield curve, though a different version of it. I consider it the best overall indicator of fundamental economic health (because it’s so granular).
(Source: Economic PI)
The BaR grid has shown to be a reliable indicator, predicting the 1980, 1990, 2001, and 2007 recessions.
Currently, 12 out of 19 economic indicators in the expansion quadrant (indicating accelerating growth), and 7 out of 19 still showing positive (though decelerating) growth. This is among the strongest readings I’ve seen in the 18 weeks I’ve been doing economic updates.
Note that over the past 19 weeks, the number of leading indicators in the decelerating, but positive growth quadrant has ranged from six to 10. In any given week, one or two indicators might flip flop between decelerating or accelerating growth. This is just statistical noise, and only long-term trends should be used as recession risk warning signs. However, that trend remains highly positive and currently moving in the right direction (stronger, accelerating growth).
Next, there’s Jeff Miller’s excellent economic indicator snapshot, a rich source of numerous useful market/economic data. It also provides an actual percentage probability estimate for how likely a recession is to start in the next few months.
What I’m looking at here is the quantitative estimates of short-term recession risks. In this case, the four-month recession risk is about 3.1%, while the probability of a recession starting within nine months is about 24%. The short-term recession risk has nearly tripled from last week and is up from an all-time low of 0.24% (since I started tracking it). While such an increase is potentially significant I don’t consider it cause for alarm. That’s because it’s just one estimate among many and the 9-month recession risk remains stable at 24%, where it’s been stable for months.
That’s especially true, given that long-term inflation expectations remain slightly above the Fed’s target and stable. If the bond market was really convinced that a recession was coming soon, then inflation expectations would be falling. This gives me some optimism that perhaps 10-year yields can stabilize in the coming weeks and avoid an inversion. That would likely signal that any potential recession might not arrive until 2021 or later.
For another look at recession risk, I like to use the St. Louis Fed’s smoothed-out recession risk indicator. This looks at the risk of a recession beginning in the current month (it’s actually delayed two months). It uses a four-month running average of leading economic indicators.
(Source: St. Louis Federal Reserve)
The way to read this graph is to understand that in the past (since 1967), as long as the reading (currently 1.7% recession risk) is under 18%, the economy has never been in a recession. This means that this graph can tell us with about a four-month lead time whether or not the economy is likely to be contracting. While the most recent spike may seem alarming, keep in mind that even if the current risk estimate were to increase 10 fold, we’d still not be at high risk of a recession starting soon.
Bottom Line: Don’t Panic Over Yield Curve Inversion Because A Bear Market Is Still Likely Least 12 to 18 Months Away
Again, I’m not a market timer, just a macroeconomics nerd (my major in college) who wants to ensure I and my readers see the big picture. Thus, the reason I provide these weekly economic updates. They are not meant for market timing purposes, but rather to allow you to prepare yourself emotionally and financially for when a recession does inevitably happen. It’s also meant to give you around a year’s warning (hopefully longer) to adapt your portfolio’s capital allocation strategy.
That might mean:
- Stockpiling some cash (to take advantage of future bargains during a bear market)
- Putting new capital to work in more defensive companies (utilities, healthcare, telecom, consumer staples); or
- For the most risk-averse investors potentially moving some money into bonds.
My personal plan is, when the 2/10 yield curve inverts, allocate 50% of weekly savings to cash. If the curve falls to -1%, then it means a recession is coming fast, and I’ll be putting all my weekly savings into cash. However, because my portfolio strategy consists of overweighting in the most undervalued and low volatility sectors (with recession-resistant cash flows) I’m going to continue buying for the next few months at least.
As for worries about the yield curve inverting, well I clearly share those. It’s never a good idea to ignore something that has predicted recessions with 90% accuracy for the last 50 years. That being said, remember that even if the yield curve inverted tomorrow, it would likely be at least another 12 to 18 months (and potentially as long as two years) before a recession started. And while bear markets are far harder to time, historically speaking, they usually come 12 to 18 months post inversion. Thus, there remains no reason most investors should be getting overly defensive right now.