Overnight between August 13th and August 14th, the 10-Year U.S. Treasury Interest Rate dropped below the 2-Year U.S. Treasury Interest Rate. In the investment world, this is known as a “Yield Curve Inversion.” The inversion of the 2-year and 10-year treasury is significant because historically every recession has been preceded by an inversion of the 2-year and the 10-year treasury rate and because it is uncommon to experience this yield curve inversion without a recession occurring within 22 months of the inversion.
Since 1970 there have been 11 inversions of the 2-year and the and the 10-year U.S. Treasury Rates. They occurred in August 1978, September 1980, January 1982, January 1989, August 1989, March 1990, June 1998, January 2000, January 2006, June 2006, and August 2019. Interestingly, most of these inversion ended with the stock market up in the both the twelve and the twenty four months following the inversion. The equity markets passed through periods of uncertainty and fell during each of the periods, but the market's losses were usually quickly recovered.
To put things in context, we will provide a brief summary of these eleven inversions and the market's outcome following the inversion. From the day the first inversion occurred in August 1978 through next twelve moths, the market was flat, and after two years, the market was up over 13%.
The second inversion took place in September 1980. Investors who stayed in the market would have been down 5% twelve months after the inversion occurred, and if they'd stayed in the market for two years they would have been up 3%.
The third inversion (January 1982) resulted in the market being up 29% twelve months after the the inversion. Twenty-four months after the inversion the market was up over 48% from its price on the day the inversion began.
The fourth inversion that began in January 1989 resulted in the stock market being up over 24% twelve months after it started. However, after 24 months, the stock market had stumbled again and gave back some of its earnings, leaving it with a gain of 13% over the two-year period.
The fifth inversion, beginning in August 1989, left the stock market with a 2% loss after twelve months and a 16% gain after two years. The sixth inversion led into a twelve month period when the stock market appreciated 12%. The 2-year return ended with the market up over 27%.
The seventh inversion looked much like some of the previous periods; the market was up 22% twelve months after the inversion and up over 39% two years later. The eighth inversion began like some of the prior inversions, with the stock market down about 3% twelve months later. However, two years after the inversion began the market was down almost 20%.
The ninth inversion, beginning in January of 2006 saw a gain in the market of more than 13% twelve months after the inversion, and a gain of only 6% two years after the inversion began. The tenth inversion resulted in a market gain of 21% after twelve months, and a gain of 12% two years after the inversion.
The moral of the story here is that while a recession very often follows an inversion of the yield curve, the market, more often than not, is up in both the 12 month period and the twenty four month period following the inversion. The average annual return of the 1-year period following an inversion (over the last 10 inversions) is +11.7%, and the average annualized return over the 2-year period following an inversion (over the last 10 inversions) is +7.6%.
The media, and many investors, have become hyper sensitive to the news. We see evidence of this behavior regularly. The President sends a tweet that the market likes, an the market climbs 2% or 3% in a day. The President sends a tweet the market doesn't like, and the market drops 2% or 3% in a day. When the Fed makes an announcement, if the market likes the news, the market may climb 2% in a day, and if they don't like the news, may just as easily drop 2% in a day. Looking at the data over rolling twelve month periods smooths out the highs and the lows; stocks do after all follow their earnings.
We believe the memory of the 2008 bear market is contributing significantly to the hyper sensitivity to news and the fear in the market. We believe this fear is an emotional response and largely irrational. Why? Because so many of the facts are so different between 2008 (or even 2000) and now. Consumers were highly levered in 2008; in 2019, consumers have a much healthier personal balance sheet. In 2008, corporate profits were driven by purchases made with borrowed money (remember the Home Equity Loans many used like ATM machines?). Today, income, personal savings, and personal liabilities are much healthier. Underwriting standards in 2008 allowed borrowers who would have normally been denied credit to borrow large sums of money with stated income loans (no income verification), no-money-down loans, and adjustable rate interest-only loans. Today's underwriting standards have returned to a rational level. Income must be verified, credit scores must demonstrate the borrow has a history of repaying his/her debts, and if a borrower wants an interest only loan, he/she must be approved for a fully amortized payment at the highest rate the loan could ever have.
So what are we recommending? We are recommending that rater than trying to time the market (an accomplishment no one has ever yet achieved with consistency), you follow your investment plan and the fundamental data. Rather than respond to the news, follow the earnings and the economic data. If the economy is growing (positive GDP) and earnings are growing, the stock market should continue to move higher despite the bumps in the road along the way. We have seen it happen over and over again. We have also witnessed a few people who HAD TO REACT TO THE NEWS OF THE DAY, and paid the price for doing so. Before investing, we run a financial plan and assess the viability (success ratio) of that plan. After confirming the expectation of a successful outcome, we invest in the recommended portfolio. In the planning process we review expenses, income, assets, life expectancy, individual goals, etc. and then suggest a portfolio allocation that we believe will get you through the “ups” and “downs” of the market (including weeks like this week).
We will continue to monitor the economic data as this story unfolds, and if we see that GDP is starting to slip into negative territory, or if we see that earnings are expected to fall, then we will share that information and react accordingly.