Don't Fall Into The Inverted Yield Curve Trap. It's Like Hotel California

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Includes: AGG, EFA, IVV
by: Dale Roberts
Summary

There's a lot of chatter about the inverted yield curve and how it can predict recessions.

The charts are impressive and there appears to be some predictive power. But certainly that timing of the predictions (to recessions) is an issue.

The problem is, this is all not 'investable'. When do you get out? When do you get in?

Once again, sensible and consistent and patient long term investing is the way 'to play' the inverted yield curve and that next recession.

Search 'inverted yield curve' on Seeking Alpha or via Google and you'll have enough reading to get you through to next Christmas. If you do Google and do read all of those articles I do apologize in advance for wasting more than a year of your life. There are a 10 pages on Seeking Alpha as a beginner set.

Of course, this is the only article that you need to read :) right?

OK, lets start off with those scary charts. The red circles point out those yield curve inversions, the grey bars represent those dark and gloomy days of recessions. OK, so the yield curve inversions appear to precede recessions. Sometimes they appear quite close to those recessions, sometimes well, not so much. If one swallows or dives into this land of inversion, when do they get out? When do they get back in? At what rate, on what schedule, do you reinvest to take advantage of lower stock prices? Do you get back in with a dollar cost averaging strategy? Do you get back in by investing based on bands or ranges of stock market drops? Let's say you reinvest some at 20% drop, some at a 30% drop, some at a 40% drop and the rest at a 50% decline. What if you don't get those market declines? Some of the recession stock market declines were not worth paying much attention. They did not offer up much of an opportunity.

If you move to safety or move a large portion of the portfolio to cash, those assets might go backwards when you factor in inflation. Going backwards is usually not a good event if it goes on for too long.

What if we get that scenario leading into the 1980's back to back recessions with near constant yield curve inversion? We're out for the whole period? We're in for the whole period? We're in and out and in and out again. Is Deja Vu investing a good investment strategy? We'd have to check in with Yogi Berra on that one.

Look at that false start in the late 90's.

Once you start moving your monies around based on yields and yield curves, where does it end?

And as has been widely reported in many of these yield curve analysis articles, the US stock market on average delivers about a 21% average return from date of inversion to date of recession start. So out of the gate the buy and hold and add investor has a 21% lead compared to investors who run away with that inverted yield curve tail between their legs. How is the investor who flees going to make up that 21%? Sure, maybe they've earned a little interest while they wait, but they've still got lots of 'making up to do'.

If we look at the financial crisis and that inverted yield curve, an investor who uses the yield curve to exit the markets might have moved to safety in January of 2006. That investor would have passed on 22% gains from 2016 to end of 2017 before the you-know-what started to hit the fan.

2 years is a long time to wait on the sidelines. What if it takes 3 years 4 years for the next recession to arrive from time of yield curve inversion? Most investors would likely second guess and hop back in or start to move back into the markets perhaps adding monies near the market top for that cycle. Patience would be a challenge if your investment thesis is not working out or is not playing out to the expected schedule.

But thanks inverted yield curve for the friendly reminder.

Now here's where I like all of this yield curve chatter; it's a reminder that states the obvious - markets do not go up in a straight line and that corrections and even recessions are almost inevitable. Major market corrections are normal and expected events.

But we always prepare for the next correction; we are always prepared for the next major correction. We prepare ourselves emotionally, we prepare our portfolio to match our risk tolerance level and time horizon.

And we never know when they might appear. Recessions can occur back to back to back, this from thebalance.com

Recessions can even stop and start as they did in 1980-1982. And yes, recessions could be spaced out by a decade or more. We simple don't know the schedule that is in store. As you may know, economists have predicted 7 of the last 3 recessions.

So we are always prepared. We simply do not know where we are in "the market cycle". That is a spurious claim to know where we are in a market cycle. That's akin to being lost in the mountains with no compass or GPS and claiming to know where you are. There is no GPS for recessions or stock market corrections.

So here's an example of how a sensible investor would prepare and make it through the greatest correction of our lifetime - the financial crisis. Let's start around the period of the yield curve inversion, January of 2006. The investor has $250,000 and is investing $1500 monthly. With that $250,000 portfolio the investor is not comfortable being 'all in' stocks (IVV) so she has a bond component (AGG) of 25%. She has also has embraced international diversification and includes developed international markets (EFA).

The investor does not guess, or waiver. She continually adds new monies and rebalances on an annual schedule to bring her portfolio risk level back into check. Here's what that investment journey 'looks like'.

The returns are not 'spectacular' but they are very solid considering that we are moving through the steepest market correction in our lifetime.

The investment schedule slightly boosted the time weighted returns to a personal or money weighted rate of return of 6.5%. That investor has experienced some wonderful wealth building.

As we know time and consistency are the greatest equalizers, able to take on the greatest challenges of stock markets and investing. The time to prepare for the next recession was perhaps in 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017 and today.

Perhaps it's not wise to start playing that stock market timing game. Because once to start, you can't stop. You can check out any time you like, but you can never leave.

Instead you might embrace a simple portfolio and get that Peaceful Easy Feeling.

Author's note: Thanks for reading. Please always know and invest within your risk tolerance level. Always know all tax implications and consequences. If you liked this article, please hit that "Like" button. If you'd like notices of future articles, click the "Follow" button.

Disclosure: I am/we are long BNS, TD, RY, AAPL, NKE, BCE, TU, ENB, TRP, CVS, WBA, MSFT, MMM, CL, JNJ, QCOM, MDT, BRK.B, ABT, PEP, TXN, WMT, UTX, BLK. 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.