SPY And Recession: Early Warnings Signs

Jun. 09, 2022 1:54 PM ETSPDR S&P 500 Trust ETF (SPY)2 Comments10 Likes

Summary

  • Most investors are familiar with the dreaded signals from an inverted yield curve, which happened briefly in April.
  • It's timely and also crucial to understand the limitations of this signal before you take action.
  • It does not always work. There had been both false positives and false negatives.
  • Plus, it’s a binary signal that does not provide the granularity most investors need.
  • This article explains simple methods you can use to construct alternative signals based on the SPDR S&P 500 Trust ETF (SPY).
  • This idea was discussed in more depth with members of my private investing community, Envision Early Retirement. Learn More »

Recession Road Sign

ZargonDesign/E+ via Getty Images

Thesis

Many investors, we ourselves included, are now keenly interested in the possibility of a recession. And many of us are familiar with the dreaded yield curve inversion as shown below. At a first glance, you can see that since the 1970s, there were six recessions (highlighted by the great bars). And all six had been preceded by a yield curve inversion. So the success rate of this signal is 100% in the past 50-plus years. And this dreaded inversion briefly happened briefly recently. The 10-year treasury rates dipped below the two-year Treasury rates in April 2022.

Given the heightened interest and anxiety we've seen among our members and readers, we feel it timely to share our market insights and research tools. The main thesis is threefold:

  • First and foremost, we want to caution readers about the limitations of the yield-curve-inversion signal. Despite its 100% success rates in the past 50-plus years, it has hidden limitations that can be costly if not understood properly.
  • Second, we want to illustrate that there are other simple indicators that you can construct, for example, based on the SPDR S&P 500 Trust ETF (NYSEARCA:SPY). These signals will help provide more comprehensive, non-binary, and actionable signals.
  • And finally, based on a holistic consideration of such signals, we're seeing some early warning signs of a recession. But there's no need to panic. Some asset allocation ideas are provided.

10yr 2yr curve

FRED

SPY and "the stock market"

First, since we will be using the SPY fund in this article, a brief word about the SPY fund and "the stock market." The SPY fund is organized as a speculation trust unit, and its asset consists mainly of shares that try to mimic the S&P 500 Index. You can see that despite issues like fees, dividends, and tracking errors, its price followed the index closely in the long term. Over the past 10 years, the S&P 500 Index returned 208.9% and the SPY fund delivered 209.2%, 0.3% above the index. The small magnitude of this difference allows us to use data from SPY to construct our alternative data later.

SPY vs SP 500

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Limitations of the inverted-yield-curve signal

First, the sample size of past recessions is too limited to be statistically significant. As mentioned above, there were only six recessions in the past 50-plus years. Expanding the timeframe broader, there were 19 noteworthy recessions throughout U.S. history.

Second, the signal does not always work. There had been both false positives and false negatives even among the limited sample set. Some recessions happened without a preceding signal, and vice versa.

Third, the signal does not tell you when a recession would happen. Many times, the equity market has staged substantial rallies after the signal occurs for an extended period of time. In the long term, missing out on such rallies hurts more than avoiding the recessions (even if you indeed manage to do so).

Finally and most importantly, the signal is a binary signal. Even when/if it works, it only tells you whether the yield is inverted or not. As such, it offers little actionable guidance. Investors cannot go all out of equity because the yield curve is inverted, and vice versa. Investors need more granularity to fine-tune their equity allocation and risk exposure.

For these reasons, alternative signals are crucial. And we will describe two simple ones immediately below.

Alternative and non-binary signals

The first easy signal involves the yield spread between BAA corporate bond and risk-free rates such as the 10-year Treasury rates. An example is shown below. As you can see, the yield spread tells how the market prices corporate bonds (which is a reliable indication of equity valuation) relative to risk-free rates. The yield spread has been consistently tractable within a range of about 1.5% to 3.0%, which provides investors with the granularity they need. It doesn't only tell you whether equity is expensive or not. It tells you the degree of its overvaluation or undervaluation, so you can fine-tune your equity exposure. Currently, the BAA yield is about 2.07% above 10-year rates, within the normal range.

BAA vs 10yr

FRED

The next signal is based on the yield spread between SPY and risk-free interest rates. As detailed in our earlier article, in my mind, valuation is always relative, and it's only reasonable to evaluate valuation against risk-free rates. Dividend yields and yield spread are what we first check before making any investment decisions and we've had very good success because of:

  • The common PE or price/cash flow multiples provide partial and even misleading information due to the differences between accounting earnings and owners' earnings.
  • Dividends provide a backdoor to quickly estimate the owners' earnings. Dividends are the most reliable financial information and least open to interpretation.
  • The dividend yield spread ("YS") is based on a timeless intuition. No matter how times change, the risk-free rate serves as the gravity on all asset valuations and consequently, the spread ALWAYS provides a measurement of the risk premium investors are paying relative to risk-free rates.

Under this background, the following chart shows the yield spread between SPY against the 10-year Treasury. As you can see, its yield spread has been range-bound and tractable again also in the long term. The yield spread has been fluctuating within a stable range between 0.5% to -1.0% most of the time. The current yield spread is at a negative 1.62%, the thinnest level in a decade.

Such a thin level of yield spread signals substantial valuation risks ahead because short-term returns are closely correlated with the yield spread. The next chart shows the one-year total return on SPY (including price appreciation and dividend) regressed on yield spreads. There's a clear positive correlation, and the Pearson correlation coefficient is 0.69. Particularly as shown in the orange box, when the spread is near the upper range of about 0.0% or higher as mentioned above, the total returns in the next year have been all positive and very large (all above 10% and ranges up to ~40%+).

And again, this simple signal is non-binary. Its significant correlation with return provides the degree of shades that investors can use to adjust their exposure.

SPY

Author

SPY

Author

Final thoughts

Many of us tend to rely on yield curve inversion as a leading signal for a recession. However, it has hidden limitations that can be costly if not understood properly. These limitations include the limited sample size, false positives, false negatives, and ambiguity of the onset and length of recessions. Finally, the signal is a binary signal and does not provide the granularity investors need.

Investors can use some simple methods, based on timeless concepts, to construct alternative signals. The yield spread between BAA corporate bond and 10-year Treasury rates serves as an effective signal to quantity the valuation of equity. And the yield spread between SPY and risk-free interest rates has shown a 0.69 correlation with respect to short-term returns.

Based on a holistic consideration of such signals, we're seeing some early warning signs of a recession. On the negative side, the yield curve has inverted briefly, and the current SPY yield spread is at a negative 1.62%, the thinnest level in a decade. On the positive side, the BAA yield is about 2.07% above 10-year rates, within the normal range. We see no need to panic. But we do urge you to stay disciplined and stay with methods that you truly understand. At a grand level, the BAA spread yield and SPY spread yield are what we ourselves use to adjust our equity exposure. The specifics are detailed in this article. We do not exit all our equity positions under the current conditions, and we are comfortable making gradual adjustments.

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This article was written by

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** Disclosure** I am associated with Envision Research

I am an economist by training, with a focus on financial economics. After I completed my PhD, I have been professionally working as a quantitative modeler, with a focus on the mortgage market, commercial market, and the banking industry for more than a decade. And at the same time, I have been managing several investment accounts for my family for the past 15 years, going through two market crashes and an incredible long bull market in between. 

My writing interests are mostly asset allocation and ETFs, particularly those related to the overall market, bonds, banking and financial sectors, and housing markets. I have been a long time SA reader, and am excited to become a more active participator in this wonderful community! 


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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

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