The financial news media has been buzzing about the yield curve recently. If your are not familiar, the yield curve is the difference between short-term and long-term interest rates. When it falls below zero, it has been a good predictor of when a recession is likely to happen. We analyzed previous inversions and looked at forward returns for the stock market over different time periods. The goal is to provide investors some context around what they can expect going forward.
The analysis builds off of a previous post where were talk about what the yield curve is, why it matters, and the many ways that it is measured.
So, this obscure thing that nobody has cared about for 12 years just happened (the yield curve inverting) and now you want to know what to do about it. Historically, the yield curve inverts 18 months before the start of a recession. First off, relax. The world isn’t going to end tomorrow. And it doesn’t mean it is time to put your money under your mattress either.
Instead, let’s take an objective look at what previously happened after the yield curve inverted. The table below shows the forward returns for the S&P 500 over several time periods after the initial inversion. Admittedly, I was a bit surprised by the average results. People talk about an inverted yield curve like it is a sign of Armageddon or something.
It’s not all rosy either. The average return after three years was essentially zero. The last two recessions certainly bring down the average considerably. Sure, you’ll pick up some dividends along the way but it’s nothing like the +10% average returns investors have grown accustomed to over the last 10 years.
Now is a great time to take a good look at how your portfolio is allocated. For each your investments, take a look at how they did during the last recession. During the 2008 Financial Crisis, the S&P 500 declined 57% from the peak in October 2007, to the low in March 2009. Look at that as a worst-case scenario and adjust your risk from there.
The most important thing you can do is be aware of the potential outcomes. The worst mistakes are made when investors are surprised by what has happened and don’t have a plan for how to respond. In 2008 countless investors sold when the market was at or near the bottom. They suffered all the losses and missed all the gains that came starting in 2009. The moral of the story is, have a plan!
If you’re worried about when the next recession will occur, you might be interested in our Business Cycle Indicator.