Myth: Stocks Never Peak Until Yield Curve Inverts

Summary

Stock investors have charged to their brokers to buy stocks so far this year leading to the best New Year opening market rally since 1987.

Many investors are taking comfort in the idea that the stock market does not peak unless the yield curve inverts.

This article shows the pitfalls in using this rule of thumb assessment in present market circumstances.

JPMorgan's (JPM) Chief Equity Strategist Mislav Matejka has a note out suggesting that investors buy the dip as 2018 unfolds.

"Some warning signs are popping up, but stay constructive and keep buying any dips," he writes in a new note.

If only there were dips to buy.

Stock investors have taken the optimistic message like the one from JPMorgan and others and charged to their brokers to buy stocks so far this year. The major indexes (SPY) (DIA) (QQQ) have had their best New Year opening day returns since 1987.

No Worries - Yield Curve Not inverted yet… ha

In the JPMorgan note, one of the bullet points used to justify continued stock accumulation was based on the current slow roll Fed policy and an analysis of the current Treasury yield curve position.

"Policy tightening is in early stages - stocks have never peaked before the yield curve became outright inverted."

One of the common myths in the market is that "the yield curve has to invert before the stock market peaks", as written in the JPMorgan equity note. Although this rule of thumb is correct most of the time, in the current market circumstances, the odds are very high that it will be proven patently false in absolute terms. And the following graph points out the major risk in taking too much comfort presently by the fact that the Treasury yield curve has not yet inverted. (TLT) (SHY) (IEF) (IEI) (GOVT) (SHV) (TBT) (SCHO)

The graph shows stock market peaks in several cases when the yield curve as measured by the 10:2 spread was neither inverted at the time of the market fall nor inverted in the year heading up to the decline. They include 1953-1954, 1976, 1983, 1987, and 2015. Most of the corrections in stocks in these instances were minor 10% downturn events, with the exception of 1987. The other big stock melt down events such as 1968, 1972, 1981, 2000, and 2008 were accompanied by the classic flattening of the Treasury yield curve.

As the graph also shows, the yield curve today is showing a flattening pattern from historically wide spreads. Similar patterns led up to inversions that preceded the stock peaks in year 2000 and 2008. The current market has many of the same characteristics of the year 2000. Technology (FDN) (PNQI) (SKYY) (FB) (AMZN) (NFLX) (GOOGL) has led the market higher, and tell-tale signs of cracks in the facade are abundant, with money irrationally chasing phantom value momentum plays like Bitcoin and other cryptocurrencies. (RIOT) But will this time be different?

The Next Stock Market Crash will be Unique

Current financial market conditions are both unusual and extreme by comparison to most points in post WWII history, and therefore, investors should expect the pattern will be different when the stock market decides to roll over. Stocks have raced to record highs relative to economic output (See more detail here), the Fed is just starting a major balance sheet dump-a-thon which will create $50B a month in new public market debt supply by October 2018, with other world Central Banks beginning to follow suit, and Congress just passed a major Tax Reform package for the first time in over 30 years. And, by the way, the oil market (OIL) (XLE) (VDE) has caught a sustainable bid for the first time since the breaking point in 2015.

The current set of events is most indicative of circumstances faced in 1987 and 1954, not the two most recent market swoons.

What are the facts in support of this observation?

Both time periods showed a large scale shift from monetary to fiscal stimulus injected into the market from Tax Reform legislation. 1954 showed rates still around historical lows due to many years of zero interest rate policy (ZIRP) in the 1940s and a rate market that receded due to slowing economic growth in 1953. The overall rate structure up to the point of Tax Reform passage in July 1954 was very analogous to extraordinary low interest rates today.

In 1987, real economic growth was waning, falling below 3%, but expectations of the October 1986 Tax Reform package economic impact propelled stocks higher by +30% year over year through the year leading up to the October 1987 surprise.

And lastly, in both time periods, the yield curve widened leading up to passage of Tax Reform and remained wide as the overall rate structure increased as the Tax Reform Plan was implemented and the Fed tightened monetary policy. In the case of 1954, the rate structure was set on an upward path that lasted for the next 30 years.

For these reasons, I do not believe an inverted yield curve is required for stocks to crash in the present day. Nor, should investors expect an inverted yield curve in the next year, or longer, if the Trump borrowing binge goes into full swing with a budget resolution passed and debt ceiling increase in mid-January 2018. In fact, the most likely market change in the coming year is that the long end of the interest rate curve will finally end its 30 year bull market. (See related article, National Debt Explodes Higher - Good Time To Be Short Duration)

When will the Shoe Drop?

The real question is when the shoe will drop on the current surging market given the major shift from extraordinary monetary stimulus to a fiscal policy path that has many questioning whether it can truly lift the U.S. economy. Currently, real GDP growth remains stuck around 2%, far below the grand 4% level boisterously posited by the Trump, who is well known to exaggerate reality at every possible opportunity.

The market will eventually produce an answer. Market momentum seems to show that a crash is not likely in the very near term, but it may well pull-back briefly. Most market mavens are convinced they need only wait for the yield curve to invert to avoid any catastrophic investment losses; and, as long as it does not, the coast is clear. With this sentiment backdrop, it is likely to take some time before pressure from the Fed and world Central Bank accommodation dampens market animal spirits. After all, the "smart" money managers are sure they can exit faster than anyone else and they don't want to do so until Treasuries provide a higher yield to park money as the market falls. The porridge is just not the right temperature yet.

Risk Will Happens Fast - Unless the Trump Magic Dust Works

But just like in 1987, I suspect that risk will happen fast unless, of course, the throwback Trump Administration's plan to recreate the glory days of the 1950s is successful.

I currently expect to see the interest rate change experienced from 1954 thru 1957 over the next three years, but very different stock return levels.

Daniel Moore is the author of the book Theory of Financial Relativity. All opinions and analyses shared in this article are expressly his own and intended for information purposes only and not advice to buy or sell.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.