Monthly Economic Update March 2019 – The Yield Curve Inverted
You’ve probably heard the yield curve inverted, and we will cover that. But what I am going to review with you is critical so you understand what’s happening in the world of money. Not just in the world of the stock market. I’m writing this one day early, it’s Thursday, March 28, 2019, and obviously, tomorrow is the end of the month. So, you’re not going to get a full quarter to view of what’s going on.
We’re going to spend some time looking at the history of the bond market, the yield curve inversion, and we will also look at what I believe is a corporate earnings recession on the horizon and potentially an economic recession on the rise — nothing to be alarmed about because these are cycles. The economy goes through expansion cycles, and the economy goes through contraction cycles. Business cycles go through expansions and contractions. They’re all normal cycles.
Let’s start out by looking at what the stock market has done so far this year. You’re going see this and think this is one of the best quarters that we’ve seen in recent history. And since you had a quarter this good, that means that the next quarter is going to be good and the whole year is going to be great. But there’s a lot of contradicting information out there right now.
Looking at some of the different indices year-to-date. You can see in Figure 1 almost every single index, and it doesn’t matter which one it is. The rising tide has lifted all boats. We’re seeing gains in the first quarter in the pure mark on the high-end, the NASDAQ at 15% and on the low-end it’s the Dow Jones Industrial Average being the straggler, up 9.82% (not pictured in Figure 1).
If we look at these indices over the last six-months (Figure 2), you can see what’s going on right now. What was our high-end looking year-to-date, the NASDAQ, is not doing so great over the last six months. We’re negative across the board during the previous six months. You can see the huge dip that formed in December of 2018.
We’ve seen a huge run up so far this year, and that’s where all the positive news is coming from. However, I want to bring it back to what’s going on today, and it doesn’t make any sense. There are times in the market where emotions and news will drive the market more than fundamentals. Fundamentals are always important because, at the end of the day, it’s still about fundamentals. Nonetheless, during short periods fundamentals may not make any sense and the markets may do something different than what fundamentals say they should be doing.
S&P 500 Earnings-Per-Share Change
As an example, check out Figure 3, the solid line is earnings-per-share change on the stocks in the S&P 500 so far this year. What do we see? We see a direction where the earnings-per-share change is going negative. Not just negative and a little bit, it’s going negative significantly. At the same time, stock prices are climbing. Fundamentally, you have to have earnings. A company has to be growing earnings in order for stock prices to increase long-term. One of two things is going to happen, and it doesn’t take a genius to figure it out either. The earnings are going to catch up with the stock prices, or the stock prices are going to catch up with the earnings.
The projection for corporate earnings this year is down from last year, and you see more negative revisions on companies in the S&P 500. There’s also this enormous corporate debt bubble that is I think has actually formed and could potentially burst if we do see an economic downturn. We will discuss the effect the combination of the yield curve inverting and this might have in more detail below.
Interest Rates & the Inverted Yield Curve
Let’s go to interest rates. There has been a lot in the news about how the yield curve inverted. I’ve been talking to you for the last six months in our past Monthly Economic Updates, pretty much every single month, about how the yield curve has been flattening. Which means that you can get almost as good of yield on a short-term treasury as you can on a 10-year treasury. Well, guess what? Now the yield curve is inverted.
As of March 28, 2019, I can get about 2.45-2.46% on a three-month treasury. If I go to a 10-year Treasury, I would be at 2.38%., this means if you’re going to loan money to the government in the form of Treasury for a short period of time, three months, they are going to pay you more interest than if you agree to hold that money there for 10 years. This doesn’t make any sense.
The Inverted Yield Curve Historically
So, you have a higher yield on the short-end then you do on the 10-year. We are ignoring the 20-year and the 30-year because those don’t come into play when it comes to economic forecasting.
Looking at Figure 4, on the right we have a chart of the S&P 500 from today back to 1999. On the left is what I want to point out to you which is a normal yield curve. A normal yield curve is going to look something like the chart to the left of Figure 4 where short rates are lower, and long rates are higher. This is what would be called a normal yield curve. The longer you agree to leave your money on deposit the more interest you get.
The Dot Com Bubble
In Figure 5, we’re going back to 1999. In January of 1999, we all know that we were in the middle of the Dot Com Bubble and the yield curve was relatively flat.
As we move forward in time, Figure 6 , look what happens to the yield curve in August of 2000 where the yield curve inverted. You can see higher yields on the short-end of the yield curve than on the long-end.
I want you to take a look at what happened to the stock market when the yield curve inverted. The stock market starts to fall Figure 7. The Fed pushes down rates and we come back to a more normal yield curve. But that doesn’t mean that the pain in the stock market is over, right?
In Figure 8, you can see where it, and you get a steep yield curve. You can see significantly lower lows and higher highs on the long-term. As the market economy recovers you get a steep yield curve. A steep yield curve stays in place during recovery.
The Great Recession
In Figure 9, we can see the market had been going up until late 2006. Look what we happened, the yield curve inverted again. Then the market continued up, and the yield curve remained flat or began inverting more and more until mid-2007.
In Figure 10, we have a strong inversion on the yield curve, and the market continued up for a few more months. But eventually, that inverted yield curve told us that we were going to have a recession. That was the 2008 financial crisis.
When we came out of the 2008 financial crisis markets were going up, and we see that steep yield curve again, Figure 11.
The Inverted Yield Curve Today
Fast-forwarding up to when we started talking about this last year. The yield curve has is flattening. In Figure 12, we are looking at February of 2018 and the short yields are starting to catch up with that 10-year yield.
In Figure 13, we’re looking at today March 28, 2019, you can see the short-term yield higher than the 10-year yield, and we have an inverted yield curve. All we have to do is take a look at the last three times it inverted! The questions are: When is the recession going to hit? How deep will it be? And how will it impact the markets?
The Yield Curve Inverted, What does that Mean to Me?
We live in the Midwest, and when the storm clouds form and the tornado sirens blow, we know it’s time to take cover. I’m telling you this because what we’re seeing is the formation of the storm clouds. We could continue to see the markets up over the next several months. But this inverted yield curve, from a fundamental perspective, is showing me that in the not-too-distant future there’s probably going to be some pain in the economy.
We are at the end of the economic cycle of expansion and threatening to go into an economic cycle of contraction. You’re going to get all kinds of opinions on this. Some people are going to say it’s different this time. Fundamentals are fundamentals though, and we could see the markets continue up. But as this gets a little bit further along, it’s clear based on what the bond market is telling us that we are not going to see the same expansion in the future that we have seen over the last few years. And more likely, we will see a contraction.
Emotions, News, and the Fed
We compare that data and that knowledge with what we see on the earnings-per-share from corporations in Figure 2 and what stock prices have done. It leads us to believe that what we have is emotion and news driving the markets. And what I mean by emotion and news is this, Jerome Powell drove a freight train into the stock market in the fourth quarter of last year. He kept saying the Fed was going to raise rates and not only are we raising rates in 2018 we’re going to raise rates two or three maybe four times in2019. And all the sudden, Powell acquiesced the day after Christmas 2018 announcing perhaps the Fed won’t need to raise rates next year.
Now he’s saying probably not. The news and that emotion are what’s causing the stock prices to soar at the same time that we see corporate earnings declining. From a fundamental standpoint, this makes zero sense which means that it is probably going to look more like what we saw in 2000 and 2007. I believe, September 20th of last year could be the top of what we see for the market for quite some time. But that doesn’t mean that you make wholesale changes to your portfolio!
What it means is you need to sit down with your advisor. Don’t put this off, we’re not clairvoyant, we can’t read your mind, and we don’t know what emotions are going on inside of your head. You need to talk to us, talk to your advisors here at Barber Financial Group and have them walk through how your portfolio would likely withstand a recession. Talk about what the plans are for your particular portfolio and most importantly how it fits into your overall long-term game plan.
As I said at the very beginning of this video, recessions are normal, expansions in the economy are normal, and contractions are normal in both business cycles and economic cycles. It’s not something that can be avoided, however, it is something that we can stress test within your financial plan make sure we are positioned the right way to make sure that you can accomplish everything that you want to accomplish. We look forward to seeing you in the office and talking to you. Thank you so much for spending some time with me today.
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