The stock market has felt brutal the past several weeks, no doubt about it. The widely-reported point swings on indexes like the Dow and NASDAQ seem eerily reminiscent of the 2008 Financial Crisis, so it's natural to be concerned. This is all a bit overhyped by the media, but that goes with the territory.
We've been reviewing definitions to key finance terms lately, but with the stock market going through another manic phase, I wanted to address some of your concerns. I'll do so by presenting a few graphics and then explaining the significance of each.
While there are any number of risk factors to consider, let's review one that came up in the media last week – inverted yield curves. You may recall prior posts where we discussed the yield curve and its importance as a recession indicator. Short of rewriting those here, this is one of those areas of finance that's not intuitive and the details get pretty wonky, so please let me know of any specific questions.
The gist of monitoring the yield curve has to do with its near-perfect ability to predict an impending recession. When the yield curve "inverts" (when short-term bonds yield more than long-term), this signals risk aversion, declining business and personal investment and, ultimately, a slowing of the economy typically leading to recession.
Investors monitor several different curves, but the most important are the difference in yield between the 3mo and 10yr Treasury bond, and the 2yr and 10yr Treasury bond. Those curves are "flattening" (the difference in yield is getting smaller) but are not yet inverted. They can stay flat for a long time and inversion isn't a forgone conclusion. But last week the less important 2yr and 5yr Treasury curve did invert and caused a bit of a stir.
Some members of the media took this news and ran with it, implying that a recession was right around the corner. What they didn't say was that the curve in question isn't as good an indicator and that the more important curves hadn't yet inverted. This seemed borderline irresponsible and helped stoke the volatility fires last week.
But if the more important curves happen to invert and their predictive power holds true, when might a recession begin? The average time from inversion to recession is about 20 months, but the actual timeframes all over the place. The following chart from JPMorgan illustrates this issue.
So why, you may ask, is the market freaking out about recession risk if such an important indicator isn't flashing red yet? Perhaps ironically, the answer has more to do with just how quiet markets have been in recent years. Yes, we've had periods of volatility, but they've generally been short-lived. What we've had more of are longer periods of calm. Since markets can't stay quiet and increase in perpetuity, the longer we go without volatility the harder it ultimately hits.
When you think about it this way, and then you think about the plethora of unsettling news we've been hearing lately (geopolitical and otherwise), the markets were ready for a serious bout of manic behavior. The following chart from Bespoke Investment Group shows how low markets have been pricing risk since the Great Recession and how we were due for an uptick.
What does all this mean for you? Frankly, it should serve as a reminder that investing in stocks and bonds is a long-term endeavor because returns grow over time. More time also smooths out volatility. The following chart from Vanguard illustrates how your chances of success grow massively the longer you invest. Investing for one day is basically a coin flip but time can be on your side if you let it.
There may still be more volatility looming out there in the short-term, and you can pick your catalyst. Regardless of what the markets throw at you, it's important to stay diversified, keep calm, and above all stick to your plan. If your plan needs to be updated, fine, but don't let market volatility knock you off your game. And remember, if it were easy everyone would do it.
Have questions? Ask me. I can help.
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