I’ve mentioned in recent weeks about the “yield curve” being inverted. This happens when bond yields are backwards and short-term bonds yield more than long-term. Since this situation is a near-perfect indicator of a coming recession it’s absolutely something to pay attention to. But is the bond market actually telling us a recession is coming, or could it be pulling a head fake? What about investor sentiment? What’s that telling us?
The yield curve briefly “uninverted” last week after several weeks of inversion before inverting again. Sounds a little strange, right? Bond investors are currently betting with 100% certainty that the Federal Reserve will lower interest rates when they meet at the end of this month. Investors are also pricing in more cuts later this year. Presumably, the only reason the Fed would cut rates is if they think we’re at risk of sliding into recession, so basically that’s what the bond market is telling us. As we edge closer however, the bond market is fidgeting a bit with anticipation and so is the stock market.
Stock investors love declining interest rates because cheaper money helps juice stock prices a little longer, even if it just delays the inevitable. This thinking is what has, at least in part, been driving stock prices higher lately. But it’s interesting that even though stock market indexes like the S&P 500 have hit record highs (the S&P closed over 3,000 for the first time last week), typical “retail” investors have for many months largely been shunning stocks in favor of bonds.
Monitoring “fund flows” is important because retail investor sentiment is often seen as a contrarian indicator. They buy late, buy too much, and generally crowd in after the “smart money” has already started leaving (think lines out the door at a local brokerage office as investors waited to buy tech stocks in early 2000 just before the bubble burst). That retail investors are generally sour on stocks is telling and could mean the markets and the economy have more life in them after all, even if the Federal Reserve sees fit to lower interest rates.
The following comes from my research partners at Bespoke Investment Group and shows fund flows into and out of stock and bond mutual funds. Look at the last chart and compare the selling retail investors did in January following the lows last December. Retail investors sold almost as much as they did during the depths of the Financial Crisis. Was last December like the fall of 2008? Some investors certainly thought so. Where’s a level head when you need one?
The second quarter of 2019 (Q2) seemed full of continued trade-related market volatility and speculation about interest rates. Both categories each sent the markets down and then up again during the quarter. While May saw stocks fall 6+%, the quarter ended on a high note brought on by, you guessed it, more news about trade and interest rates.
Here’s a summary of how major market indexes ended the quarter and year-to-date, respectively (as a reminder, the YTD numbers look very strong, but this is off deep lows in December):
- S&P 500: up 4.3%, up 18.5%
- Russell 2000 (small company stocks): up 2.1%, up 17%
- MSCI EAFE (foreign stocks): up 4%, up 14.5%
- MSCI EM (emerging markets): up 0.7%, up 10.8%
- U.S. Aggregate Bonds: up 3.1%, up 6.1%
The financial sector was the top performer during Q2, showing growth of about 8%. Technology continued its strong performance and is the best performing sector this year, up about 27% YTD. Energy stocks performed poorly, down about 3% during the quarter. Although the sector performed well during June as oil prices rose to the high-$50’s per barrel, it wasn’t enough to make up for poor performance during April and May. Gold was up as well, about 10% YTD with almost all that performance happening in June.
As has become all too familiar lately, trade rhetoric and geopolitical concerns caused a lot of market volatility during Q2, both positive and negative. April and May saw more tweets from President Trump about potential new tariffs directed at China followed by a short-term tariff-related row with Mexico. The latter ended up fizzling but was enough to add a layer of uncertainty to markets already digesting the resignation of the British PM after failing to deliver Brexit. Much of this tension eased, however, as we entered June and markets took off for the remainder of the quarter.
Before we begin, I wanted to say a few words regarding my post from last week. I had written about the importance of charging rent to “boomerang kids” when they move back home. The idea is to welcome them as the adults they’ve become with an understanding, on both sides, of what’s expected.
This isn’t to suggest that you charge rent in all cases, however. Our kids could move back for any number of reasons and many of them, such has health-related issues, personal trauma, and so forth, would (and should) reasonably be free from rent for obvious reasons. I failed to mention this last week and wanted to clarify that here (thanks for the reminder - you know who you are).
Now on to this week’s post…
As often happens in the short-term, financial markets are all over the place. Stocks have moved up from recent lows, but the interesting activity has been mostly in the bond market. I’ve mentioned previously how the yield curve is currently inverted and how this has been a good indicator of an oncoming recession. Let’s update where we stand.
My research partners at Bespoke Investment Group put out a very good piece last week addressing how long the yield curve normally stays inverted before it starts flashing a bright red light, so to speak, for a coming recession. As shown in the graphic below, out of the seven recession periods (the gray bars) in recent decades, the yield curve has been inverted for at least 30 days, but more commonly at least 50, before being a better signal.
If you look closely, you’ll also see a lengthy inversion in 1967 that didn’t precede a recession, as well as a couple of blips as outliers in the late 90’s. While not a foregone conclusion, our current inversion is about 20 days old, so we’re knocking on the door of this becoming a more meaningful indicator.