"A crisis is a terrible thing to waste," announced NYU professor Paul Romer. The scene was California in 2004 at a venture-capital meeting. Prof. Romer referred to the profit opportunities in severe market dislocations. He was speaking of the previous market crisis, the "tech wreck;" but he gave good advice for the developing crisis that would envelop the world.
I will present a series of articles with simple tools that identify a crisis and take advantage of its alpha generation. I will then apply the tools to a specific investment - in this case, the largest component of the S&P 500 Index, Apple (NASDAQ:AAPL).
The first tool is a fundamental economic indicator - the yield curve. The yield curve helps identify our stage in the economic and investment cycle. The equity market usually follows the curve's lead because of the powerful forces behind fixed-income. Two of these forces are discussed near the end of this article.
Shape of things to come
The yield curve outlines the shape of things to come in the minds of those who invest in U.S. government bonds. This curve tells us where a large group of investors thinks those interest rates and, therefore, the economy will go in the future. They buy bonds that fit their expectations for future interest rates.
The yield curve has forecast so many changes in the economy that the Federal Reserve includes it in their econometric models. You can see their work in the free publication "Economic Trends" on their website.
Business economists use the two-year/ten-year spread for their forecasts. The Federal Reserve uses a slightly different calculation. It measures the yield curve from the three-month bill to the ten-year note. Short-term interest rates move before long rates, so the Federal Reserve's model may be an early warning system for the economy.
A normal, or upward-sloping, curve generally indicates a strong economy in about a year. A curve that runs downhill, or inverted, suggests a recession. The steeper the curve, the stronger investors expect the economy to be. Conversely, when that spread shows a negative number, there is usually a recession coming.
Yield Curve's Forecasting Record
How has the curve helped investors through past cycles? The publication "Economic Trends" addresses this question with a graph going back to 1953. The shaded areas are recessions. You can see that the curve tends to invert before a recession and normalize before the recovery. This graph is in the middle of this page.
We saw a similar occurrence during the recent investment cycle. The curve inverted in late 2006 as housing peaked. The stock market peaked several months later.
Several extreme values of this spread provided guideposts for investors during the last cycle. When the spread line dipped below zero and the curve inverted, investors had an indication to sell stocks. They could have gotten back into the market when the spread widened in 2009 and 2010. Here is what the stock market did from 2003 to 2012.
Superimposing the S&P on the graph of the yield spread shows how the spread tends to lead the stock market. It also helps identify two major turning points. Investors can take advantage of this with the ETF for the S&P 500 Index (NYSEARCA:SPY).
The yield spread was narrow in the middle of 2006 as the housing market peaked. This narrow spread forecast slow economic growth ahead. The curve inverted in August 2007 after a 57% increase during this investment cycle. Investors could have used the inverted curve as an indicator to take profits and lock in that 57% gain.
The spread moved into positive territory later in 2007 as the stock market reached its peak. The normal shape of the yield curve suggested that there was hope for the economy and the stock market in about a year.
As sometimes happens, exuberant equity investors ignore warning signs from the fixed-income market. They do so at their peril because the fixed-income market usually prevails. As Bill Ferdinand, Managing Director at U.S. Trust said during this period, "The longer we have to wait for this recession, the worse it will be." He was right.
By October of 2008, the financial crisis was in full swing. The Federal Reserve supported the economic system with several forms of financial assistance. These activities changed the shape of the curve and caused it to become unusually steep. The ten-year note was almost four percentage points higher than the three-month bill. Investors were worried about inflation rather than recession; it was an opportunity to buy stocks.
Forces that Drive the Curve
There are two forces driving this tool: the size of the market and government participation.
The bond market, for many years, was roughly twice as large as the stock market. Now that investors seem be have less confidence in equities, that ratio is higher. Daily trading volume in the U.S. bond market now averages about $800 billion, according to the Securities Industry and Financial Markets Association (SIFMA). Equities, on the other hand, average closer to $110 billion. This ratio is close to 8:1 as the bond market is almost eight times the size of that of equities.
The Federal Reserve Bank of NY is one of the largest fixed-income buyers. Recent monetary policy has required that the Fed buy massive amounts of bonds in order to keep interest rates low and stimulate a struggling economy. If that is how the Fed feels, an investor might as well invest along with this powerful player.
Application to Apple
Let us drill down into the S&P 500 Index and apply this tool to Apple. This stock is so rich that small percentage changes in price translate into large dollar changes in your portfolio. Therefore, you do not want to miss an opportunity; but you certainly do want to avoid large losses in this volatile stock. Here is how AAPL outperformed the index by 250% since 2009.
Apple investors needed to protect themselves during the crisis, but it was critical for them to re-enter in 2009. The S&P may have increased about 50% since then, but AAPL increased five times that much. The yield curve is one tool that gave investors the courage to commit funds during the dark days in the spring of 2009.
What about Apple's unnerving volatility since the worst of the crisis? Notice how the yield curve changed direction prior to that of Apple's price. The curve is a good indicator of the "risk-on/risk-off" mentality that plagued investors during the summers of 2011 and 2012.
Finally, where are we now in the economy and the market? As of this writing, the yield curve has been narrowing for the last week as investor confidence improves. The S&P closed down today despite the bond market's optimism. Apple, in particular, suffered. It is probably a good time to buy this stock.
The yield curve is one expression of the Fed's intentions. The stock market reflects investors' confidence in our economy and the companies in it. We are fortunate to have the yield curve as a window into these components of production. If the curve predicts the future of the economy, you can bet that stock market investors, who focus on firms' profits, will pay attention.