Slowing economic growth and an inverted yield curve has many investors worried about a potential recession in the next year or two, but also has them excited for the heady stock-market returns that have often been sandwiched between an inverted yield curve and the subsequent economic downturn.
But some analysts and economists are warning that statistical averages can be misleading, and that there is reason to believe that the latest yield curve inversion signals returns for the rest of year will be tepid at best and that the stock-market top may already be in.
Oliver Jones, market economist for Capital Economics told MarketWatch that while it is sometimes the case that stocks continue to deliver strong returns for many months after a yield curve inversion—as they did in the lead-up to the 2007 stock-market peak—it is by no means the rule, and already weakening economic data suggests that equity investors won’t be so lucky this time around.
“We already see evidence of payroll growth slowing, retail stales beginning to weaken and less U.S. demand for imports, at the same time that we’re seeing signs of a corporate earnings slowdown,” Jones said, arguing that these weren’t traits the economy displayed at the time of the 2006 yield curve inversion.
An inverted yield curve is a situation where short-term interest rates sit at or above long-term rates, a dynamic in the government-debt market that can be a precursor to an impending recession, as it indicates investors believe that growth will be weak.
On Friday, the yield on the 10-year Treasury note TMUBMUSD10Y, +1.36% fell below the yield on the 3-month T-bill TMUBMUSD03M, -0.12% An inversion of the 10-year/3-month curve is the most reliable indicator of potential recession, according to researchers at the San Francisco Fed, having preceded the past seven such downturns.
Read: The yield curve inverted — here are 5 things investors need to know
Capital Economics
Jones noted that over the past seven instances when the yield curve inverted, three of those instances saw the S&P 500 index SPX, +0.36% peak before the onset of a recession (see table above). He predicts that this time around, the market will behave as it did in 1973, when the market peaked six months before the yield curve inversion.
“The 1973 rerun seems plausible to us, even though we are projecting a sharp slowdown in growth rather than a recession. Indeed, we continue to forecast that the S&P 500 will end 2019 at just 2,300, roughly 18% below its level now,” wrote Jones’s colleague John Higgins, in a Thursday research note.
Others have argued that stocks are likely to repeat a pattern that’s seen stocks, on average, gain ground in the months after the curve initially inverts — a phenomenon they attributed in part to investors reallocating to equities in response to lower yields, as well as a typically more accommodative stance by the Federal Reserve.
See: Why an inverted yield curve doesn’t mean investors should immediately sell stocks
Archive: Here’s when the yield curve actually becomes a stock-market danger signal
Mike O’Rourke, chief market strategist with JonesTrading disagreed with this analysis in a note to clients Wednesday evening, preferring a different example of a market peak that preceded a yield curve inversion by pointing to the year 2000 as an important corollary to the current situation.
“The S&P 500 bull market peaked on March 24, but the yield curve didn’t invert until 3 months later. The ensuing recession didn’t occur until March of 2001, which was a year after the equity market peak and nearly 8 months after the yield curve inverted,” he wrote.
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He likened the current market environment to the dot-com bubble days, writing that “we are once again dealing will a bubble environment where underlying assets are disconnected from fundamental developments. The favorites of this era are also the disruptive companies that are changing the world where valuation is an afterthought.”
The state of the markets don’t look much better from a technical perspective either, according to Mark Newton of Newton Advisors. While he is still predicting current bull market to peak sometime later this summer, it won’t happen before a significant pullback in April, while the S&P 500 will only “get a little bit above the 2930” level at which it peaked back in September. He then predicts a bear market to begin in 2020.
“In the short run you’re seeing serious warning signs,” Newton said. “The recent slowing of breadth and momentum leads me to think that April will be tough,” he added, while the overbought condition of the information technology sector is another red flag. “When tech is 20% of the market, and it stalls out, there won’t be another sector to take its place,” he said.
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