We’re officially in correction territory — what to expect now, and what the yield curve inversion is signaling for later
The big news today is that the granddaddy yield curve inversion of them all — involving the 10-year Treasury and the 2-year U.S. note — has officially triggered.
This inversion has been heralded by many as a recession indicator.
In fact, according to Credit Suisse, there have been five inversions of the 2-year and 10-year yields since 1978. All were precursors to a recession.
That said, there is a significant lag time between the inversion and the recession itself. The ensuing recessions occurred, on average, 22 months after the inversion. And during that time, the S&P 500 actually climbed — posting average returns of 15% over a period of 18 months after the inversion.
The last time this key part of the yield curve inverted was in December 2005, two years before the recession hit.
News of this morning’s inversion is rattling markets. As I write Wednesday mid-day, the Dow is down 600 points. Starting from our peak back in late July, the S&P has now sold off around 6%.
But taking a step back, what does all this really mean?
It’s a bit of a mind-melt … We now have calls for an impending recession … but until then, 15% gains for the S&P … Meanwhile, we’re in “correction” territory with the market down 6% — is it going to keep dropping? By how much? When do we bounce back?
Beyond that, some analysts are suggesting that “this time is different” in regards to this morning’s yield inversion. They suggest the drop in the 10-year Treasury yield is more reflective of international money pouring into the U.S. treasury market because of its strong yields (relative to lower and negative yields in international markets), rather than reflective of bad economic conditions in the U.S.
So, what’s going to happen?
To answer these questions and help contextualize this correction, let’s turn to John Jagerson of Strategic Trader.
Regular Digest readers recognize John as one of the smartest quant analysts in the business.
Being a “quant” simply means John uses real, historical market data to identify patterns and trends. Then he uses that information to help make well-informed predictions as to what might happen in the markets going forward.
***What to look for from the markets given our current correction
Jeff: John, set the stage for us. What’s the big-picture snapshot of what’s happening?
John: After a short bullish head fake on Tuesday, the major indexes erased those gains and dropped to a new short-term low today. At this point, we can safely say that the selling that started on July 31st is a “correction.”
The current decline has so far maxed out with a loss of 6% on the S&P 500, which is a little less than the -7% loss during the last drawdown in May and June. Generally, technicians consider any decline of -5% or more to be a correction, and these losses are close to average over the last 10 years.
There are a lot of negative factors creating the weakness in the market, including an inverted yield curve — which usually precedes a bear market and correction by 10-18 months — slowing manufacturing in China and Germany, and of course the ongoing tariff war.
However, we would make an argument that as long as growth isn’t negative, we will likely see stock prices bounce back before a recession has a chance to kick in.
Jeff: Okay, so we’re down 6% … At what point should investors be more concerned that a bounce isn’t going to happen? Is there a line in the sand at which this “correction” turns into something bigger?
(NOTE: John provided the chart below for your reference as part of his analysis.)
John: I found 17 corrections since the market bottomed in early 2009 with an average decline of 9.81%.
There were a few outlier corrections that technically qualified as bear markets included in those 17 declines, like the 20% losses that took place in 2016, 2018, and in 2011, which was triggered by the European debt crisis.
On average, they lasted 61 days, but there were some outliers in that respect as well with the 2011 correction lasting 157 days.
Despite the broad range of losses and length, the historical numbers can still help us establish a benchmark for the current correction when investors may want to take further action.
For example, 76% of the corrections that dropped at least 7% led to losses of more than 12%. So, if the current decline closes below 2800 on the S&P 500, short trades or other protective strategies are warranted.
Jeff: As we’re talking, the S&P is at 2846, so it’s only about 1.6% above this 2800 line-in-the-sand. What about a bounce though? If we can carve out a bottom here, what kind of bounce-back might we expect?
John: Once a bottom is formed, regardless of how long that takes, the 30-day return from a long position averages 8.87%.
I would not be surprised to see more definitive progress in the trade dispute serve as the catalyst for a bounce higher in late September. Investors should build a list of stocks with exposure to tariffs — retail, industrials, tech — that could be added to a portfolio if an agreement between President Trump and President Xi can be reached.
Jeff: Returning to the yield curve inversion from this morning, do you truly believe it signals a recession? On one hand, we have this indicator predicting prior recessions with a relatively high degree of accuracy. Yet, we also have other analysts suggesting that the declining 10-year yield is based on capital flight — basically, global investors funneling money into the U.S. since yields in their own countries are so low. What’s your take?
John: The capital flight argument is a fair point, but I don’t agree that this factor precludes the potential for a recession. I agree that U.S. Treasuries are attractive compared to alternatives, but I think other economic signals — slowing manufacturing, dropping commodity prices, etc. — confirm the deteriorating economic situation. So, I do think the yield curve inversion is a valid precursor to a recession.
Jeff: Just to make sure we’re on the same page here — when you say “recession,” I’m assuming you’re referencing the traditional definition of some negative economic growth — not a repeat of the near-financial-apocalypse of 2008/2009.
John: Yes, when I think of a recession, I am thinking of a bear market for stocks and 2-6 quarters of negative economic growth, not a repeat of 2008-2009. That’s really not a terrible worst-case scenario. If investors weren’t worried about economic growth then U.S. Treasury bonds would not look attractive at current yields.
Jeff: So, if a recession is in the cards for us, what about gains for the market between now and then? Should investors stay long?
John: The potential for gains after an inversion is definitely true. Yes, I think investors should stay long for now, with a focus on large-cap growth stocks that are paying dividends.
There is usually plenty of time to make adjustments as the situation progresses. Once we see economic growth in the U.S. flip negative, then I think investors should start shifting more aggressively into hedged positions.
Jeff: Okay, so can you give us one final takeaway on everything?
John: There are some negative signals out there but this isn’t the time to sell.
I recommend investors focus on high-quality equities that have been able to grow this year despite trade headwinds. Good retail, consumer staples, and even large tech stocks look good once they hit support.
Investors should monitor the situation carefully, but no panic is necessary. The scope of the drawdown hasn’t been deeper or faster than the other 17 we have seen since 2009, so I think the biggest risk right now is that investors leave too early and miss out on another 10-14 months of gains.
Jeff: Thanks, John.
***It turns out, one of the analysts that believes “this time it’s different” regarding today’s inversion is our own Neil George
As editor of Profitable Investing, Neil is a master income investor, so anything involving rates and yields is in his crosshairs. Given that, I wanted to turn to him as well for his thoughts.
Here’s how Neil evaluates what’s pushing down U.S. Treasury yields:
What is really happening is that the U.S. is the haven economy in a world where Europe is in trouble and the leading economies of Asia are slowing. And as a result, yields for government bonds from the leading issuers in Europe and Asia are increasingly heading into negative yields.
Negative yields and interest rates around the world beyond the U.S. are rapidly becoming a growing problem as the amount of bonds with negative yields keeps climbing by the day to a current level of $15.83 trillion.
Negative Yield Debt Around the Globe Source: Bloomberg
This in turn is making the U.S. bond market all the more attractive with positive yield and in turn is driving more buying from investors inside the U.S. and beyond. And with more buying of longer-term bonds — yields are down, and prices are up.
But what about the historical significance of the yield curve inverting, and that being a precursor to a recession? I asked Neil about “this time being different.”
Yes, we will not be seeing a recession.
The U.S. isn’t just a haven — it is a powerhouse. It stems from the 2016 elections. There have been numerous major industry deregulation and regulatory reforms which have unleashed investments and profits fueling growth from financials, petroleum, industrials, utilities, real estate — especially REITs with the tax cut.
This is what Europe and Japan need to get their economies back on recovery. And it’s why the U.S. economy was hobbled for years after various legislative and more so capricious administrative application of regulations.
All of the great efficiencies in the U.S. economy are what is behind the low and falling inflation, thanks to so much investment in so many varied industries — particularly in the application of technology to all sorts of businesses and industries.
***What both John and Neil agree on is that more gains are likely in store for the markets
So, as we move forward from today, from a technical perspective, we should watch John’s suggested S&P level of 2800 as an indicator of how deep this correction may go. But once we carve out a bottom, history suggests we’ll see a bounce of almost 9% within 30 days.
Following that bounce, with a medium-term timeline, both John and Neil agree we’re likely in for more market gains.
As to what may happen in regards to a recession 10-14 months from now, we’ll monitor that as we get closer. But for now, it appears “long” is the call once we navigate this current volatility.
We’ll continue to keep you up to speed.
Have a good evening,