The YCI... Revisited... Again...

 

Once again "market pundits" (the talking heads on TV and the people writing the click-bait on financial websites that passes as news) are making hay about the dreaded "yield curve inversion". 

 

What is a yield curve inversion (let's shorten it to YCI for the purpose of this post)? The YCI is what happens when shorter-term interest rates along the yield curve exceed longer-term rates. Generally it's not a sign of economic health, as in a healthy economy you would expect longer term rates to be higher than shorter term ones. Someone willing to lend their money for a longer period should be better compensated for it, no?

 

While central banks like the Fed control overnight lending rates and have some control over the short end of the yield curve, the longer end of the yield curve is controlled by participants in the bond markets and are more of an aggregate "guess" of where the markets see rates heading. When the bond markets are predicting lower rates in the future they price longer-term bonds at lower yields than shorter term, and we get a YCI. Basically it's the bond markets saying they don't have much faith in continued economic growth, inflation, and further rate hikes. 

 

 

Sometimes there's good reason for the bond market's prediction - and the bond market tends to be a lot smarter than the stock market in predicting things - and a YCI is followed by a recession simply because the bond market got it right.

 

Other times, like in 2007, the YCI is caused by a shortage of available short-term money which itself causes the next recession. Think companies trying to finance their inventory purchases or banks (who tend to borrow on the short, lend on the long) seeking deposits in order to write more loans and mortgages. When lending freezes up it generally leads to recession.

 

Our Chief Strategist, Tony Dwyer, has been talking YCI for as long as I remember. He also makes sure to mention, in each of his presentations, that what he watches for and is really concerned about is bank lending standards, and from his observations they continue to be very easy.

So, why does everyone care about the YCI? Well, it seems to be a better predictor than a lot of other things and it just generally attracts eyeballs to the news story when there's talk of pending recession. People have become so fixated on the YCI now that just in order to make a story of it they look at all the potential yield curve "pairs" to actively seek an inversion. What I mean by this is that it's generally the 2 year and 10 year U.S. T-bonds that get looked at as a comparison of short term to long term, but the 2 and 10 haven't inverted (yet), so in order to make a news story, people point out that the 30 day and 10 year inverted (by just a little). It seems like they're looking for whatever fits their narrative.

 

As I write this on March 29th, the 30 day is at 2.428%, the 2 year is at 2.258%, the 10 year is at 2.407%, and the 30 year is at 2.817%. That's not an inverted yield curve. More like a Nike swoosh, if anything. What can be said though is obvious: these are all still freakin' low rates! Who cares if the 30 day is a little higher? It's not at a rate that inhibits short-term lending or throttles the economy in any way. Businesses can still sell commercial paper at slightly higher rates to finance inventory or whatever other short-term cash needs. The U.S. government can still borrow very cheaply over the long-term to finance and refinance over $20 trillion in debt.

 

 

And if the 2 and 10 do invert and if it truly does predict a recession/bear market in the future, as it did most of the time in the past? This has been repeated ad nauseam by Dwyer and others: historically the YCI has had around a 1 to 2 year lead-time before the peak of the markets. Not only that, but the average return over the year(s) between YCI and market top have tended to be above average. So, in other words, anyone trying to use the YCI as some sort of short-term market signal is probably going to do way more damage to their long-term investment success than good.

 

Boeing's Burdens

 

Was hoping to not make this market update too long, but I wanted to touch on Boeing since they're in the news a lot of late and there's a little investment lesson to be learned. I don't mean to make light of the hundreds of people who died in the Ethiopian and Lion Air tragedies, but there are now more than 4 billion passenger flights globally per year and the number of fatalities is still in the magnitude of thousands, making air travel exponentially safer than any other form of transportation (meanwhile road collisions claim over 1 million lives globally each year).

 

The thing I wanted to touch on with Boeing is that it's yet another example in a long line of examples of business risk, or non-systematic risk. When investing in stocks we face primarily two risks, being systematic risk (effect of overall stock markets on your individual stock holding, ie: the December market crash took down almost everybody) or non-systematic risk (risks inherent in a particular business).

 

Non-systematic risk is what scares me the most when investing in individual stocks and it's the reason I won't touch an individual pharma stock with a ten foot pole anymore (that sector more than any other faces the most frequent and intense pitfalls, ie: failed FDA trials, unexpected fatal drug side-effects, and regular attacks from politicians over pricing). Some businesses do really simple stuff that generally doesn't accidentally kill the end user. Other's don't. Non-systematic risk is completely unpredictable and random.

 

Boeing, in this example, is (or was?) the leading passenger plane manufacturer in the world. They were eating Airbus's lunch. In any case, both Boeing and Airbus have a pretty solid business because there's such a pent up demand for new airliners that they both have order books stretching years into the future. You can own a stock for all the right reasons: solid earnings, great balance sheet, etc, but at the end of the day it can be something completely random and out of anyone's control that shaves off over $30 billion of market value, as it did with Boeing.

 

The moral of the story: tread carefully if you decide to own individual stocks. Many people consider the added non-systematic risk to be not worth it and stick with ETFs and mutual funds. Every stock is either a company with problems or a company that's going to have problems at some point in the future. Try not to buy stocks or any asset class when everything's going great for them and they look like great investments.

 

The overall market rewards you for taking systematic risk (exposing your money to overall market risk) but generally not as much for taking concentrated positions in stocks. Granted, in the case of Boeing you would have done double the average market return over the past 10 years.

 

Disclosure: Neither I nor any of my clients directly own Boeing (BA). If you want an honest opinion, I think it's still overvalued.

Tweets and Articles for February

 

Whenever I read something good, I tweet it out from @CGWM_Muhs. Follow me on Twitter if you want live updates of what I'm reading. For those who don't have the time for Twitter, a short list of some of the best stuff I read below.

 

More Stuff

 

RBC Global Asset Management's One Minute Market Update for New Year 2019 CLICK HERE

RBCGAM's One Minute Market Update is a short quarterly overview of the markets. What I especially like is their "Fair value range" charts on the right side, taking very long term views of various markets and where stocks are trading relative to long-term fair value.

 

JP Morgan's latest Guide to the Markets CLICK HERE

This 60+ page slideshow is chock full of charts, facts and figures, that give you pretty much everything about everything you could possibly want to know about the economy and markets. Want to know how U.S. stock valuations compare either historically or with the rest of the world? Want to know how much the U.S. government is borrowing? You'll find it all here.

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