Looking at the Yield Curve: Time to Reconsider Stock Market Exposure?

The economic outlook is a key factor for stock investors, and many market players will tell you to look at the slope of the Treasury yield curve if you want to know what the economy might look like down the road. Historically, an inverted curve, or when short-term interest rates are higher than long-term rates, as they are now, has been a strong indicator of an impending recession. Whither then, the stock market?

Equity markets have had a nice rally so far this year, with the S&P 500 index climbing more than 4 percent and the Dow hitting successive highs amid an inverted yield curve. A bit of history can serve as our guide for what to expect down the road and to gauge the kind of return an investor might expect if using a buy-and-hold strategy for one year after the onset of the yield-curve inversion.

Over the last 50 years, the yield curve has inverted nine times, excluding the current inversion, according to monthly interest rate data from the Federal Reserve. A recession has followed within a few months of eight of those inversions -- the only times the U.S. economy has slipped into recession in that period.

In our analysis, periods of yield-curve inversion that were separated by three or fewer months were counted as part of the same period. The one time when a recession did not immediately follow an inversion was when yields on one-year notes eclipsed the rate on the 10-year from December 1965 to February 1967. The yield curve inverted again later in December 1967 and remained flat-to-inverted until March 1970. According to the National Bureau of Economic Research [NBER], the economy sank into recession in December 1969. The table below compares yield-curve inversions and recessions since 1956.

So how has the curve impacted the stock market over the same period?

Looking at the last 50 years' worth of data, we see that there were a couple of banner periods. On average, though, investors did better getting out of stocks and putting their money into an interest-bearing savings account.

Note that overall through September this year, the S&P 500 index has been on pace to make 2006 one of those periods when the stock market has climbed amid an inverted yield curve.

Still, only nine months have passed since the most-recent yield-curve inversion. How does this period compare with others like it in the past? The table below shows the nine-month return of the S&P 500 index from the onset of the inversion.

One thing to notice is how much higher, in general, the returns are. We see that in six out of the nine periods with an inverted yield curve, the S&P 500 index's nine-month return was higher than its corresponding 12-month performance.

While this does not mean that the stock market will fall in coming months, it does give one reason to pause and reflect on exposure to the U.S. equity markets and reconsider some of the alternatives available for managing this exposure, including some of the possibilities outlined by Marc Gerstein in his article "Alternatives to options."

At the time of publication, Erik Dellith owned shares of SPY, the S&P 500 index Exchange Traded Fund.

Note: This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.

Comment on this article

Comments

[Paul Meisel:]

While I find this analysis interesting, I think of yield curve inversion in another way.

Lower interest rates in out periods mean the market expects interest rates to be reduced in the future.

Frequently in the past interest rates have been reduced because the economy needed stimulus, often because high interest rates attracted money out of equity and real investments. In my opinion, the Fed waited too long to ease causing the "hard landing".

Right now short term interest rates are not particularly high viewed in long historical perspective, and the market anticipates they will be reduced in the near future -- so long term money should want to stay in equities and real property.

Soft landing? Hard landing? My parents were pilots and they taught me that a good landing was any landing that you can walk away from.

2006 Oct 09 09:26 AM

[Barry Gitarts:]

The sample size of the inversion is only 9 times, which is not statistically significant.

2006 Oct 09 11:07 AM