The S&P 500 fell 6.5% during the month of May. While it was a tough month for the market, keep in mind the S&P is still up nearly 10% from where it started the year. The deterioration of trade talks with China and a surprise announcement of tariff’s on imports from Mexico gave investors plenty to reasons to sell.
The news also gave investors reasons to seek the safety of US treasury bonds. Interest rates fell sharply causing much of the yield curve to invert. An inverted yield curve has historically been a warning sign that a recession is on the horizon. The news media loves a scary headline (they get more views and therefore sell more ads), so they run stories about the predictability of the yield curve and how it could be the end of this 10-year bull market.
Watching the Yield Curve
We keep a close eye on the yield curve as it is one of six components within our Business Cycle Indicator. While we respect the historical accuracy of the yield curve in predicting recessions, it is often overstated. The chart below shows the 10-year minus the 3-month treasury rates going back to 1962 (the periods outlined in red are recessions). While the yield curve did invert prior to each of the seven recessions that occurred, it also inverted twice without a recession occurring (1966 and 1998).
The problem with the yield curve is that you can literally make dozens of different curves by combining any two interest rates. While the 10-year minus the 3-month is inverted, many other curves remain positive. Below is chart with nine different yield curves spanning the last 20 years – three of them are now negative, while six are still positive.
Prior to each of the last two recessions, all of these measures were negative. Now, that doesn’t mean that this can’t lead to a recession, it certainly could in time. However, prior to the 2008 recession, the yield curve first inverted in February of 2006. More than 18 months before the stock market finally peaked in October 2007.
If anything, all of this suggests that investors should not base their investment decisions because of one data point; in this case, the yield curve. Sure, it’s not a healthy sign for the economy, but it doesn’t automatically mean doom and gloom either.
Now let’s look at three more logical measures of economy to see if they confirm, or contradict, the yield curve.
When the economy begins to slow, companies are forced to cut costs which often includes laying off employees. When someone loses their job, they often file for unemployment insurance until they find a new job. The department of labor keeps track of the number of people filing for unemployment insurance. The chart below shows the 4-week moving average of the number of people who file for unemployment each week. The weekly numbers can be quite volatile, so we use the average over the last four weeks.
While the number is not declining at the pace it was in recent years, importantly, it’s not rising sharply. Prior to recessions we typically see the number moving higher, often quite drastically.
Before any new construction project can break ground, the builders have to file for building permits. The US Census Bureau aggregates this data and releases an update each month which includes the number of new building permits that have been approved. It is a good leading indicator of future construction activity. Currently, building permits are still in an uptrend, although down slightly from last year. Importantly, the decline does not appear to be of the magnitude that preceded previous recessions.
Heavy Truck Sales
Lastly, we monitor the number of heavy-duty trucks that are sold each month across the country. When the economy does begin the slow, the demand for moving goods around the country declines. Trucking companies see weakening demand for their services so they hold off on ordering new trucks. On the other hand, when the economy is doing well, more products are being shipped so the demand for new trucks rises.
Currently, new truck sales are approached the highest levels they have ever been. Importantly, heavy truck sales have declined prior to recessions. Although, there have been instances when truck sales decline and the economy does not fall into a recession.
The yield curve is a difficult concept for many investors to grasp. However, most people can understand how jobless claims, building permits, and even heavy truck sales will rise and fall with the economy. While the yield curve is sending a potentially ominous sign, other measures of the economy appear to be holding up well (at least for now).
Is This Bull Market Over?
Based on the data we shared above, we’d say no. However, investors need to realize that when an economic cycle does come to an end, it tends to unravel quickly. Financial markets are constantly digesting new information and discounting it virtually at the speed of light. Don’t believe me? I would highly recommend Michael Lewis’ Flash Boys.
This is the time to have a game plan in place for how you will respond. If the market goes down, what will you do? What if it goes up? The 2008 financial crisis was devastating and cost investors trillions of dollars. However, if you could somehow account for all the investors who sold during the crisis and never got back in, the impact was far greater. Moral of the story is – Have a plan.