A negative yield curve is the most reliable pointer to when a bull market in shares is over or nearing its end. A negative yield curve happens when shorter term official interest rates fall below longer-term ones, which is unusual.
On March 20, the USA registered its first negative yield curve since August 2006. It occurred not because short-term rates kept rising, but because medium and long-term rates fell further as the outlook for the global economy and corporate earnings soured.
What does this mean?
If the yield curve stays negative, it might suggest the US stock market either peaked last September or it is likely to do so before mid-2020. That’s based on the historic relationship of negative yield curves to market peaks and economic recessions, shown in the table below.
The link between an inverted yield curve and an economic recession is almost perfect. See the next chart dating back to 1955. Only the negative yield curve of 1965 failed to foreshadow a recession.
Source: http://www.minackadvisors.com.au/
Time to exit the market?
So does this mean it’s time to leave the share market or at least lighten up on shares? A cursory view of history would say “yes” but there are questions to ask first.
1. Is the negative yield curve firmly established?
An examination of yield curve spreads shows that their present dip into negative territory is very shallow compared with previous occasions. Also, the closely watched (red) 10 year to 2-year Treasury bond spread in the previous chart is still positive. That suggests it’s too early to say that a negative yield curve is entrenched.
2. Is this time different because interest rates are low?
The President of the Federal Reserve Bank of Boston says “yes” because previously the central bank lifted the cash rate to fight inflation, which is not a threat now. In his view, longer dated bond yields have fallen because foreign investors are chasing US yields since those in Europe and Japan are negative.
But a research paper by the Federal Reserve Bank of San Francisco concluded that:
“Periods with an inverted yield curve are reliably followed by economic slowdowns and almost always by a recession. While the current environment appears unique compared with recent economic history, statistical evidence suggests that the signal in the term spread is not diminished.”
3. Is it supported by other economic indicators?
The Leading Index for the US economy points to a slowing of growth, though credit creation, which is the engine of growth, still shows no sign of stalling.
Stock analysts are downgrading their expectations for first quarter earnings with the prospect that they could be lower than a year ago and stay so for two quarters or more. The sugar hit from Trumps corporate tax cut is wearing off and slowing global trade and rising wages are pinching profit margins.
4. Is it supported by technical indicators?
For the moment, the US stock market’s (red) 10-day trend line continues to stay ahead of its (blue) 30-day trend line, which is bullish. And its (green) 12-day momentum gauge also remains positive. Market Timing Australia’s stock market traffic signal is still on green too.
5. Is the market top-heavy enough to collapse?
On many fundamentals. America’s stock market is heavily overvalued while other markets are not.
Here is a chart that projects future returns for 20 countries based on their existing stock market capitalization to GDP ratios adjusted for historic experience. Note that Australia’s outlook is much brighter than America’s because our market is not as overstretched.
Source: https://www.gurufocus.com/global-market-valuation.php
Hi-tech stocks make up a quarter of the value of all-American stocks compared with under 1% of Australian stocks. Hence a market downturn in America could be felt less here as was the case with the dot.com bust of 2000, as illustrated below.
My conclusion
We should be alert to a bear market, though not yet alarmed. The negative yield curve needs to become deeper and wider to confirm that it’s more than a temporary blip.
Market Timing Australia’s share market traffic light is still on Green so there is no current signal to exit the stock market. Nevertheless, it would be prudent to review one’s overall investment portfolio to see if it’s sufficiently defensive to cope with a bear market.
For thoughts on the last point, read chapter 7 of my book Crash Proof, Share Investing without the Roller-Coaster Ride. A free PDF copy can be downloaded from http://markettiming.biz/crash-proof/
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