Message From Yield Curve

Includes: FLAT, IWD, IWF, STPP
by: Roger Nusbaum

Long time readers may recall that I worked briefly at Fisher Investments in 2002. My stint there was very helpful in terms of creating my own process -- I also bring in quite a few other things in to the equation and leave others out but I learned a lot there.

One interesting nugget was something related to the yield curve. The extent to which the yield curve inverts is crucially important for reasons laid out many times over in the early days of this blog (lending relies on borrowing short and lending long).

Another aspect of the yield curve is the extent to which the slope of the curve factors into growth outperforming value or vice versa. The idea as believed at Fisher was that with a flatter curve, growth stocks to better and with a steeper curve value should outperform. They felt that the reason for this is that so called value companies often issue debt to access capital markets and the debt, specifically longer term debt, is more attractive when the yield curve is steeper. This makes the bond sale successful and gives the value company access to the capital.

Growth companies tend to access capital markets with secondary stock offerings. When bond sales are unattractive then equity sales become relatively more attractive giving the so called growth company access to the capital. Value companies go the debt route because there is more in the way of earnings to dilute unlike growth stocks which tend to earn less.

In this week's Streetwise column Michael Santoli talked about the extent to which growth has outperformed value this year. The article reminded me of this aspect of yield curve analysis and sure enough the iPath Yield Flattening ETN (NASDAQ:FLAT) has outperformed the iPath Yield Steepening ETN (NASDAQ:STPP); a gain of 1.8% versus a decline of 1.8%.

Last year was odd. The Russell 100 Growth ETF (NYSEARCA:IWF) was down 0.62% and the Russell 1000 Value ETF (NYSEARCA:IWD) was down 1.00% while FLAT was up 24% and STPP was down 23%. Technically this yield curve indicator turned out to be correct but to essentially no benefit. As Karl Popper would have noted it only takes one negative occurrence to disprove a theory but I am not sure this disproves it. Still it is interesting in a market mechanics sort of way.

If this was ever very important it was probably in the 1980s, 1990s and the aftermath of the tech wreck when foreign investing played less of role for investors than it does now. While I look at this every so often I believe foreign country selection and sector weightings are far more important.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.