The month of August continued the flat theme that we chronicled in our last newsletter. While there was plenty of volatility, driving the stock market (as measured by the S&P 500 Index) down 3% on three different occasions, the end result was a stock market that gave up 0.2%. So, typically a slow month (from a trading volume standpoint), did not disappoint in its lethargy. That doesn’t mean the last month of the summer didn’t have some sizzle. This was provided by the first sighting of the dreaded inverted yield curve!
The inverted yield curve is the magical event which occurs when the interest rates on short-term bonds are higher than the interest rates paid by long-term bonds. In a normal yield curve, the short-term bonds yield a lower interest rate than the long-term bonds because investors expect a lower return when their money is tied up for a shorter period. They require a higher yield to give them more return on the long-term investment.
When a yield curve inverts, it's because investors have little confidence in the near-term economy. They demand more yield for a short-term investment than for a long-term one. They perceive the near-term as riskier than the distant future. They would prefer to buy long-term bonds and tie up their money for years even though they receive lower yields. They would only do this if they think the economy is getting worse in the near-term… to make a long story short, this inverted yield curve signals a recession. In fact, it has accurately predicted the past six recessions (see chart to the right).
Since it is a foregone conclusion that soon enough (probably not for another 18 months, based on history) we will be in a recession, isn’t the real question: What will we do then? What should we expect? How long will this last? But, before we give some recession clarity, what exactly is a recession? Simply, it is defined as two consecutive quarters of a contracting economy (i.e., GDP). Many of the signs you see of a coming recession are not present today, hence why there is so much debate about if we are headed for one.
Nonetheless, now that we know what a recession is, what is an investor to do. Well, I’d like to provide a fancy way of saying this, but I can’t. An investor should do nothing! And if you don’t believe me, take a look at this chart to the right. The pink circles are moments of inverted yield curves and the grey areas are the periods of recession. They clearly provide the substance behind what we’ve discussed. But it’s the blue line we are interested in, aren’t we?
We don’t invest in inverted yield curve or recession predictions, do we? No, we invest in the stock market (in a variety of ways) with the intention of growing our money over the long-term. Well, over 50+ years covered on this chart, we see the S&P 500 index rising many times over while the seven recessions preceded by seven inverted yield curves occurred. The unpredictability of when recessions occur and how long they will last causes many market participants consternation and many times resulting in ill-timed actions. But for true long-term investors, these tend to be blips (as well as buying opportunities) on our trek to achieving what we set out to do in the first place… grow our money!