Yield Curve Yawn

Mother's Little Helper portfolio was UP today +887.39 (+0.76%)

Overall GAIN/LOSS YTD: +$132.31 (-0.11%)

Our benchmark index, the S&P 500 is UP Year-To-Date (+4.66%)

http://money.cnn.com/data/markets/sandp/

"One component of the leading economic indicators is the yield curve.

Bond investors keep a close eye on this, as it illustrates the spread or difference between

long-term interest rates and short-term ones."

-Kenneth Fisher

I made my buys for the year on December 28, 2017, see the new portfolio here (Click Here).

The portfolio got a little bounce up today but still lags the S&P 500 our benchmark. Because this portfolio is focused on holding long term, 5, 10, 20 years or more, I'm not particularly concerned about this temporary under-performance. It's fun to look like a genius when the portfolio is up, buy hey, this is investing, and rule #1 in investing is "Don't Lose Money". So far we're not making a killing but we're also not losing money. Over our horizon I'm confident this portfolio is a conservative bet that will do well.

The Yield Curve

I'm sorry, but how did this term ever come into common knowledge? I've heard so much about the yield curve lately that it's beginning to drown out the Russia Collusion Investigation.

Quick primer: The yield curve is a graph that shows the difference in compensation that an investor will get for investing in short term bonds vs. long term bonds. The most common comparison is 2 year US Treasuries vs. 10 year US Treasuries. If you dedicate money to a 10 year bond you expect to get paid more, so the curve should be steeper vs the curve that represents a 2 year bond.

When the difference in the interest rate between 2's and 10's becomes narrow we say that The Yield Curve is Flattening. At several points in history we've seen the yield curve Invert. An Inverted Yield Curve is showing that short term rates have exceeded long term rates and is usually an indication of something going wrong in the economy. That condition typically makes investors very nervous. So let's look deeper.

Why all the scary rhetoric?

Well it turns out that every time since the 1970's that the yield curve has inverted we've had a recession in the coming months, or year, or two years. The yield curve has been a leading indicator of an on coming recession; how much of a lead, about 6 to 24 months. In the chart below we see the 2 year line drop below the 10 year constant line and eventually a recession shows up as indicated by the grey bars. Scary stuff? I once had a carnival fortune teller warn me about hair loss in my 20's, my barber charges me by the pound today. Just because we've seen patterns in charts before does not mean we will the same patterns again. More importantly, are we reading and creating the charts correctly?

For me to accept the yield curve as a predictor of a future recession I would want to know that this is universally accepted. Turns out no, it's not. The yield curve is unique to the U.S stock market but also shows up in Japan. As far as the rest of the world is concerned there is no reliable relationship between the yield curve and recessions. In fact the only correlation I can find is that an inverted yield curve and recessions are more closely tied to countries with central banks who use interest rates to control inflation (USA and Japan). With that hypothesis we should not expect to see the EU experience a recession soon after an inverted yield curve event.

Not So Scary

The 10 year vs 2 year yield curve is not a harbinger of doom, even though many in this generation of investors believe it is. The amount of predictive work going into the yield curve is a bit screwy really, I mean there are people out there actively trying to predict a predictive tool. In reality a flattening yield curve is nothing to be fearful about. Richard Bernstein of Berstein Advisers said it best; "History shows that when you have a flattish curve, very similar to what we have today, you have some of the highest prospective 12-month returns for the S&P 500,". That's another way of saying "Stay Invested".

To dig deeper I decided to look to the person who created the yield curve predictive model, Professor Campbell Harvey, a professor of finance at Duke University’s Fuqua School of Business. Professor Harvey first proposed his model in his 1986 doctoral dissertation at the University of Chicago. In his own words, 'Many were skeptical'. First it's important to note that what is commonly reported in the news is not based on his model.

Professor Harvey's model uses the five-year yield minus a 90-day Treasury bill yield, the media commonly uses the 10-year yield minus the two-year yield. Using Professor Harvey's model the yield curve is not nearly as flat. While the 10 year vs. 2 year spread is about 40 basis points, the 5 year vs. 90 day spread is about 77 basis points. Bigger is better. If you'd like to track these rates yourself go right to the source https://bit.ly/1OPO6F5. The yield curve is not inverted regardless of which spread we use. Importantly, there is only a prediction of recession when the T-bill yield is greater than the five-year yield for a full quarter. We are not near that situation so please, go find something else to worry about.

It's Different This Time?

OMG I hate that phrase. I used it once myself when I was in my 20's and I've regretted saying it ever since. What's different are the economic conditions that were created by the Great Recession. The Federal Reserve is experimenting with monetary policy that nobody has any experience with; specifically raising rates and reducing a balance sheet full of bonds and mortgage backed securities. I'm actually reassured this time that we have a banker and not an economist at the controls. Raising rates slows inflation. Reducing the assets on the balance sheet also raises rates, which will slow inflation. Raising rates too fast throws us into recession. Doing both at the same time hasn't been done before, so in my thinking the Fed needs to go slower with the rate hikes because there's not much they can do about maturing bonds that fall off the balance sheet. If I could ask Jerome Powell for one favor it would be to stop doing both balance sheet reduction and quantitative tightening at the same time. Both have the effect of raising rates, but the actual impact on the economy will come later, delivering a shock when we're not expecting it.

The only thing I can predict with 100% accuracy is that there will be a recession, at some point, in the future and that's normal. When it occurs the market will decline and those who put aside some cash will reap huge rewards by buying great companies at discount prices. For now, there is nothing in the US or global economic data that would suggest that a recession is eminent. Follow the 5 year vs. the 90 day, if it inverts, start putting cash aside to be a buyer, not a seller of stocks.

Trade War

I'm working on an extended 'deep dive' article about the current trade war with China, Canada, Mexico and the EU. This subject effects everyone, investors and non-investors alike so I'll be investing extra time and column inches to try and make sense of the really big picture.

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Keep Me Honest

I am attempting to keep track of my calls and predictions by logging them at the bottom of every post.

  1. Bond prices will decline as a result of rising rates and a Dollar Shortage.

  2. Invest in China stocks. NetEase, YY, JD, Baidu, Alibaba, mobile phone services and makers, and China BioTech

  3. Invest in Whirlpool (see Whirlpool caveats above), Kohl’s, Costco Wholesale, Home Depot, Dollar General and Casey’s, Ingersoll-Rand, Illinois Tool works, Paccar, Honeywell, and DowDupont, PayPal, Square, Goldman Sachs, Citibank, Bank of America, JP Morgan, DBC, Apple, Microsoft and Caterpillar.

  4. Goldman Sachs slides to around $210/share

  5. Proctor & Gamble, Coca-Cola, Merck and Pfizer will go lower as rates rise.

  6. The Chinese yuan will replace the dollar in international trade. Not this year, but it will happen in coming years.

  7. The DOW will close the year with 9-10% gain.

  8. The S&P 500 will close the year at 2900-3000.

  9. The portfolio will generate about $2,065 in dividends.

  10. M&A of drug companies will increase over the next 24 months.

Stay Invested,

Clay Baker

Disclosure: I am personally invested long in some or all of these funds that appear in the Mother's Little Helper portfolio or manage these investments for my Mother's portfolio and may purchase or sell shares within the next 72 hours. I am also invested in other stocks and funds that do not appear in the MLH portfolio but may be mentioned or related to this article. It is not my intention to advise or encourage the purchase or sale of any security. Since I may on occasion discuss Bitcoin and other cryto currencies I disclose here that I personally own investments in the cryto-currencies listed here: AMZN, DBC, VTI, VWO, VEA, VIG, XLE, MUB, TBT, GLD, Bitcoin, LiteCoin

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. This article is not intended to offer investing advice, guarantee 100% accurate predictions, or to be interpreted as providing a personal recommendation.

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This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice.
This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities.

© 2016 by Clay Baker all rights reserved