There are arguments to be made that "this time is different” in interpreting inversion. However, there is also more-than-enough uncertainty around these arguments for investors to refrain from dismissing the warning sign being derived from the yield curve.
Having said that, let's put the yield curve debate aside and focus in this article on portfolio strategy and asset allocation.
Tech is Leading, Healthcare is Lagging
First of all, take a look at the best and worst performing stocks in the S&P 500 (SPY), so far this year.
The technology sector (QQQ, XLK, VGT, FDN, IYW) is particularly strong, with 8 names (or 405%) making up the top 20 list: Xerox Corp. (XRX), Xilinx Inc. (XLNX), Arista Networks Inc. (ANET), Cadence Design Systems Inc. (CDNS), Keysight Technologies Inc. (KEYS), Garmin Ltd. (GRMN), Advanced Micro Devices Inc. (AMD), and Synopsys Inc. (SNPS).
Interestingly, there are also three names (or 15%) belonging to the healthcare sector (XLV, VHT, IBB, XBI, IHI, FBT, IYH, FXH, IXJ) making the top 20 list too: Alexion Pharmaceuticals Inc. (ALXN), Celgene Corp. (CELG), and Incyte Corp. (INCY).
Why do we say "interestingly"? Because when we look at the list of the bottom 20, the healthcare sector is sending no less than nine names (or 45%) to the weak/wrong side of the performance comparison: Biogen Inc. (BIIB), CVS Health Corp. (CVS), Cigna Corp. (CI), ABIOMED Inc. (ABMD), AbbVie Inc. (ABBV), ResMed Inc. (RMD), Centene Corp. (CNC), Humana Inc. (HUM), and Bristol-Myers Squibb Co. (BMY).
Note that the technology sector doesn't have even one representative on the bottom 20 list.
The tech strength, combined with healthcare weakness, very much aligns with the overall picture regarding sector performance this year.
Bonds - In, Stocks - Out
While dovish, most Fed officials keep saying that it's premature for investors to expect a rate cut, since the chances of a recession are not particularly high right now.
Of course, "not particularly high" must be put in the right context.
From an absolute perspective, one may claim that at 29%, the NY Fed's recession model - measuring the probability of a US recession over the next 12 months - is "not particularly high".
On the other hand, when we realize that 29% is a higher probability than what was reported 12 months before 5 out of the last 7 recessions, that number suddenly looks particularly high.
It's all relative and/or in the beholder's eyes, I guess.
Just like the yield curve, let's put this probability for a recession aside and focus on portfolio strategy. Because, with or without a recession, the shift in investors' appetite is not only noticeable but also alarming.
The divergence between flows into stock and bond funds is growing, with investors piling into debts (AGG, BND, LQD, BSV, TIP, VCSH, VCIT, SHV, EMB, SHY, HYG, SHY, IEF, TLT, JNK, AWF, BKLN) and out of equities (SPY, DIA, QQQ, IWM, IVV, VTI, VOO, VTV, IJH, IJR, IWM, IWF, VUG, IWD, VIG, VO, IWN, IWO, IWD).
So much so, that corporate bond ETFs are not only poised for their biggest quarterly inflow on record...
...but the lowest-rated US investment grade bonds just had their best quarterly return since 1995.
The speed and magnitude of the shift (from stocks to bonds) is being reflected in the amount of negative yielding bonds. Only few months ago the amount of negative yielding debt was around $8 trillion. Now it's back to $11 trillion.
A rise of $3 trillion, or circa 40%, in a matter of few months is showing the extent and severity of the madness of negative interest rates and monetary policies that function as nothing but a non-stop printing machine.
Mad (Bond) World
Now, if you think that using the word "madness" above is a bit too harsh, allow me to demonstrate to you why "madness" is actually an understatement.
Take a real good closer look at the yields of a few ultra-long sovereign debts:
- Italy (EWI) 50-Year: 3.50%
- US (SPY) 30-Year: 2.83%
- UK (EWU) 50-Year: 1.41%
- Austria (EWO) 100-Year: 1.41%
- Japan (EWJ, DXJ) 40-Year: 0.53%
- Germany (EWG) 30-Year: 0.53%
- Switzerland (EWL) 40-Year: 0.19%
In case you missed that from the above chart, allow me to repeat and focus on the yield on Austria's government bond that matures in 2117.
1.44%... for almost 100 years... I wonder if the holders already have plans for the money once the bonds mature...
As a reminder, we believe that a dual, highly correlated rally of both stocks and bonds is unlikely to last for too long. Such a conundrum is neither sustainable nor making any sense taking into consideration the underlying reasons.
Either the economy is in a worse shape than many believe and the bond market is correct (meaning stock prices need to adjust downwards), or the economy is in a better shape than many hope and the stock market is correct (meaning bond prices need to adjust downwards).
Growth (or whatever is left out of it...)
US Q4 2018 GDP growth cooled by more than initially reported, signalling more mounting challenges to the decade-long expansionary cycle.
US Q4 2018 GDP growth was revised downward to 2.2% from the initial 2.6% reading, and even lower than market projections for a revision to 2.3%.
Many believe that the German government is quietly preparing plans to fight a recession, except that Angela Merkel doesn't want to tell Germans that the good times may be over, as many (mostly politicians) worry that voters are not yet fully prepared for what's waiting ahead.
Truth (and the god news) is, recessions have become less frequent over time. According to NBER data, we are now in the longest period without a recession since 1900.
Putting it differently, there's no "expected", or "right", time for a recession to takes place.
The bad news (and another truth) is that at 30x, the Shiller PE suggests a very low, or even negative, return for the S&P 500 Index during the next decade.
It's clear to me that we're witnessing a tectonic, historical change. That change is starting with monetary policies, but it also applies to investors' portfolios.
Moving from an aggressive approach to a more defensive approach certainly makes perfect sense to me at this juncture, even if it means taking some golden-technology chips from the "black" and putting those on the healthcare "red".
Of course, technology and healthcare can - and should - be treated both literally and figuratively in the context of this article/message.
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Disclosure: I am/we are long CELG, ABBV. 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.