Survival In The Post-Yield Curve Inversion Environment

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About: SPDR S&P 500 Trust ETF (SPY), Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VOO, VTWO, VV
by: Alexander Veytsman
Summary

Yield curve inversion is not synonymous with the immediate beginning of the bear market.

Given that the economy is in the late stage expansion cycle, the timing of yield curve inversion is logical.

S&P 500 is likely to revisit its highs in the near term.

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On August 14, the crisis bells sounded quite loudly on Wall Street: the yield on the 10-year bond fell below the yield on the 2-year bond for the first time in more than a decade. An anomalous pattern in the bond market, yield curve inversion has historically preceded every recent US recession. Understandably, the markets suffered a meaningful plunge, with the S&P 500 index closing at 2,841 on August 14, more than 6% below its most recent high of 3,028.

Is the recession coming? - the ominous "R" word once again captured the minds of most investors, this time giving technical support to some things that could be in store.

Nearly three weeks later, as some passions have cooled off, we can comment on the yield curve inversion from a more historical perspective, which should hopefully provide us with a healthy dose of both comfort and apprehension. Finance textbooks teach us that past performance is not an indicator of future performance in the stock market. However, if we give credence to yield curve inversion being a recession harbinger solely based on historical trends, then we should allow ourselves to cautiously scrutinize it from a historical perspective as well. Apples to apples, so to say.

First, we need to remember that yield curve inversion is not synonymous with the beginning of the bear market. In fact, in the aftermath of previous inversions, the S&P 500 index still managed to register all-time highs every time before slipping into the bear market. Sometimes, the decline commenced within months after initial inversion; sometimes within 2 years. This in itself is a counterintuitive observation: if market participants are so convinced that the yield curve inversion precedes recessions, then why did they push the S&P to a new high every time? Yet, that's what history tells us.

Second, yield curve inversion is inevitable for the simple reason of being on everyone's minds. If we look at historical yields during every economic cycle of the last six decades, we note that during the year five or year six of each expansion, yields begin a downward trajectory, as demand for safer longer term Treasuries grows and as expectations for Fed's rate reductions increase. We have seen this trend materialize since 2016, only to reach its pinnacle in 2019. With more than ten years of economic expansion behind us, demand for 10-year bonds kept on rising throughout this year, as investors eventually yielded to historical patterns and inverted the curve.

Third, should we start worrying and flee from the equity market? Well, the S&P is still within a striking distance of its all-time high and it's not inconceivable for it to mark a new high in the near future and potentially push higher. This pattern would be entirely consistent with previous yield curve inversions, which should provide us with some comfort level at present. However, once that new high is reached, there is no guidebook to indicate if the bear market is about to begin or if we should give the S&P index a few more percentage points, before pulling the plug.

Such is the dilemma of the yield curve inversion. Survival in this brave new world is tricky, but entirely manageable.

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.