The 10-2 Indicator Says No Recession, Market Collapse

A popular indicator is the 10 Year Treasury yield less the Two Year Yield.  When the number is positive or upward sloping, that is typically indicative of a growing economy.  The short version is that the Fed heavily influences the short-end of the curve, so when investors are confident about the economy they sell the long-bond pushing the yield up. 

Now the Fed can and will, as evident by quantitative easing (the Fed buying longer dated bonds), control the long-end too.  Thus, even though we have an upward sloping curve now there is still some heavy Fed influence as they are keeping short-term rates very low.  Further, the drawing down of quantitative easing (no longer buying longer dated bonds) expected Q1 next year should push up the long-end of the yield curve.

Still, even with that caveat I found the chart below pretty fascinating.  The blue line is the 10 Year yield less the 2 Year yield and the red line is the S&P 500.  

A few things stick out:

1. A negative sloping yield curve has ALWAYS led to a recession.  There all no false positives.
2. We have never had a recession since 1976 (from when the data was available) where the yield curve did NOT turn negative beforehand.
3. The last two major markets tops in 2000 and 2007 coincided with a negative yield curve.
4. We don’t have anything close to a negative curve now.  In fact, the slope is moving higher.  

While the sample size is small and everything works until it doesn't, it bares extremely well for the economy.  This has important stock market implications.  I have noted before that even if earnings lag (say the economy is weaker than expected or the record high profit margins come down) we can still have multiple expansion to push the market higher given short-term valuations are not at extreme levels.  That isn't to say the market can’t or won’t have a hiccup or pullback around 20% or so, just that a larger bottom doesn't appear to be in the cards unless that 10-2 indicator reverses. 

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

Can Deflation Stop the Rally?

Will deflation doom stocks?  If prolonged logic dictates it will.  Lower cost = lower earnings = lower prices AND higher real rates = good alternative to stocks = lower valuations.  This is why looking at the latest CPI numbers it’s at least a tad concerning:

The chart shows disinflation and is getting worse -- see the arrow.  Currently inflation is running a little under 1%; thus, we are currently not in deflation, but disinflation.  An article in FT highlights the concern moving forward:

“’The lesson of the past, [CLSA], is that the three previous times the US rate of inflation dropped below 1 per cent since 1957 — 1998, 2001-02, and 2008-09 — stock market investors suffered significant losses.’ … 

In 2002, during the period when Ben Bernanke made his infamous helicopter money speech, stocks fell by almost a third after US inflation dropped below 1 per cent. 

Also, in 2008, inflation fell through that 1 percent line days before Lehman Brothers filed for bankruptcy.”

I decided to dig a bit deeper and put together my own data table – here.  I was looking for points in time when inflation for all items (there appeared to be little link between inflation ex. food and energy) was lower than both our current level of inflation and subsequent one year returns.  Here is the summary:

To me the data and subsequent analysis shows the following:

• First there is a small sample size, so certainly findings should be taken with a grain of salt.
• Returns are lower and the probability of a negative return over the next 12 months is elevated.
• But the lowest return, while large, still isn’t a bear market and I wouldn’t consider it catastrophic, especially with diversification and risk control.
• And there are still positive returns with some large ones even.
• What’s also interesting is the negative correlation (lower inflation number = higher forward returns), which on the surface seems counter intuitive…
• Until you take into account that as these numbers worsen the Fed will ease more and thus provide a bump to the markets.
• When you look at the 2009 data, this illustrates that.  The big fall in the market coincided with disinflation/deflation; however, once we fell below 1% the 12 month forward returns on the S&P were all positive.
• Thus, my view is even if disinflation persists, based on recent history the Fed will step up and pump up the inflation number, and subsequently the market.  Now if the Fed doesn’t step up or their efforts no longer work, then the risk of negative returns on stocks is elevated.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

By Definition, Black Swans Can’t Go Away

If everyone can quantify the risk that the world will burn, then if it goes up in flames it’s now allowed to count as a black swan (or blind tail risk) event. 

The term black swan, made famous by Nassim Nicholas Taleb, refers to a phrase from a time London when they wore funny clothes, and powdered wigs.  At the time everyone thought a swan was white, thus a black swan was viewed as impossible or at least improbable.  Without getting too philosophical, the phrase refers to risk to which the consensus is totally blind, either because their premise or their process is wrong.  Basically a black swan risk is a huge catastrophic risk not many see coming - the unknown unknowns (i.e. we don’t know the risk or the outcome).

As outlined by Business Insider, large scale risks are off the table in 2014:

“Betting against a U.S. financial collapse was a great call. Betting against a Eurozone crash was a great call. Betting against a Chinese hard landing that threatened the whole world was a good call. Betting against a debt ceiling default was the right call.”

Those assessments were totally correct.  Further, the risks of those events moving forward have been substantially diminished; however, those were all known unknowns (i.e. we knew the risk, but not the outcome).  A common misconception is that risks like the aforementioned are black swan events: they are not, and the reason is the consensus at the very least saw these coming head on.  On the surface this seems like a debate in semantics, though it’s more practical to one’s portfolio than that. 

While it’s true those aforementioned risks are now less likely than before, as the article points out the market has probably priced that in by now.  Thus, our conversations with clients on risk are shorter, our bullish thesis is stronger, and our asset allocation observations are lower on conditionals (e.g. stocks will have a good year if various European countries don’t replay the French Revolution). 

Therein lies the issue, investors are now more confident that those large scale risks are diminished.  This is true for what everyone can see, but can NEVER be true for actual black swan events.  Further, as the known risks seem to evaporate the probability of being oblivious to a true blind tail risk event inherently becomes greater.

All of this is a nice way of saying be prepared for anything, never be too strong in your investment convictions, or dismiss anything outright.  The ways to accomplish this are through proper diversification, discipline, the use of out-of-the-money put options, and other prudent risk management techniques.  This is also why I have been bullish, but never omniscient.    

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.