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Rekenthaler Report

A Bit of Good News

The yield-curve indicator is not flashing...yet.

Dark Clouds
Wall Street is at its gloomiest since 2009. China's slowdown, plummeting commodity prices, and flattening corporate profits have frayed nerves. Star bond-fund manager Jeff Gundlach stated late last year that if oil prices got down to $40 per barrel, that would indicate that "something is very, very wrong with the world." Oil's price as I write this is $30.14. Royal Bank of Scotland went further, issuing the direst client warning I have ever seen from a mainstream investment firm. RBS says that 2016 "looks like 2008." It advises to "sell (mostly) everything."

While I am generally of a sanguine nature, I confess to being uncomfortable as well. Today's bear theory is sounder than most. No question that China and other developing markets have spent heavily on capital investments; that commodity companies have responded by expanding capacity; that the combination of those two activities has juiced the global economy; and that both those booms have faded. Sometimes the pessimists fake it--such as 2009's baseless speculation that stocks would suffer because of "uncertainty" about future U.S. tax policy--but in this instance the concerns are real.

That said, there's a long gap that separates the ability to foresee economic troubles from the ability to forecast financial markets. (Peter Lynch: "The way you lose money in the stock market is to start off with an economic picture. If you spend more than 13 minutes analyzing economic and market forecasts, you've wasted 10." He did not completely believe that, of course, but mostly.) Even if the economy hits the expected wall, that doesn't mean securities will follow suit. Other measures, such as those based on stock prices and investor sentiment, are also instructive.

The Yield Curve Indicator
Investment writer Bill Bernstein (here is his primer, and here is his advanced class) has provided just such a measure--the yield curve indicator, or YCI. (A true friend is one who sends not only a story idea, but one accompanied by data and charts!) When long U.S. Treasury bonds yield more than Treasury bills, as is typically the case, stocks are usually in good shape. In contrast, an inverted yield curve, with long Treasuries paying less than cash, often suggests trouble. Researchers aren't sure why that is--I think it might be because inverted yield curves indicate a tight monetary policy, while Bernstein supports the behavioral notion that investors think that "cash is trash" during stock euphorias--but, for whatever reasons, such is mostly the case.

By and large, Bernstein's charts support that thesis. For the most part, high YCIs are associated with benevolent stock markets, and low scores occur around times of trouble.

Early Years
The first two decades available for the data set, which begins in the familiar year of 1926 (the birth of the universe, per the Book of Ibbotson), show a simple pattern: a steady decline, a blow-up, and then a long period where YCI was steady.

  - Source: Morningstar

YCI was prescient in the 1920s. As the stock bubble expanded, the Treasury yield curve became increasingly negative. Its lowest point was in June 1929--four months before Black Tuesday. You can't ask for much better than that.

The indicator was not very successful in the 1930s through the mid-1940s. In the broadest sense it was on track, as a steadily positive curve was accompanied by a recovery in stock prices. (From 1933 through 1945, U.S. stocks gained 25%-plus in six calendar years.) But it utterly missed the severe 1937 setback, caused when the Federal Reserve prematurely tightened interest rates, and it missed the World War II-related downturn of 1940-42.

(Even in the 1920s, however, YCI would have been only marginally useful for timing the stock market. Get out in 1926 when the indicator first turns negative? Get back in when it briefly spiked upward? Sell in early 1928 as YCI went further into the red? Wait until 1929? Hold out even longer? As Bernstein writes, YCI can serve as an "ancillary market signal." It provides one of many answers to the question of whether stocks are in a bubble. To ask more of YCI, as with asking more of the Shiller P/E ratio, is to ask more than the statistic can give.)

Postwar America
During the next 40 years, YCI was mostly on track.

  - Source: Morningstar

The indicator stayed steadily positive from World War II's end through the mid-1960s. So were stock-market returns, as the S&P 500 had 16 up years in 20 attempts, with the four down years being only mildly in the red. During that period, YCI gave no false negative signal. While it did do some bouncing, it never reached the point of suggesting investor caution. Which was appropriate, as the U.S. postwar stock market strongly favored buy-and-hold investing.

YCI then got very bumpy, along with stock prices. The indicator did not anticipate the 1966, 1969, and 1973-74 downturns, but rather moved along with them. That is, when each of those declines began, YCI was positive, but as stocks fell, YCI joined suit. The indicator moved quickly enough that it remained moderately correlated with future performance; for example, YCI turned sharply negative by mid-1973, when most of that bear market's losses had yet to occur.

Modern Times
For the final stretch, from 1985 until present, YCI registered three hits, one modest miss, and one complete miss.

  - Source: Morningstar

The hits were in late 1989, 2001, and 2007, when YCI dipped into the red. In the first and last cases, YCI correctly anticipated the carnage that was to follow. In the middle case, that of 2001, it once again followed the equity market rather than led it, but as the tech-stock sell-off lasted a full two and a half years, YCI did not arrive too late at the wake.

The misses occurred in 1998 and 1987. With the former, the indicator briefly dipped negative during the midst of a surging bull market that would continue for another year and a half. It was a short and slight signal rather than a blaring indicator, so the result should be treated accordingly--but nonetheless, it landed on the wrong side of the facts. On the latter, YCI was blindsided. It utterly missed 1987, just as it had utterly missed 1937 five decades previously. (Maybe it's a half-century thing?)

Today, the figure is safely positive, as it has been for seven years now. There's nothing in YCI to give an investor pause.

Ray of Light?
I won't make too much of the information derived from a bear-market indicator that fully missed two of the worst downturns of the past century and arrived mid-even at several others. A positive signal here is far from overwhelming evidence. On the other hand, YCI has likely been a more reliable stock-market guide than any economist. (An economist who correctly foretells even a single bear market is an economist who has a reputation for life, even if he misses the next three.) Its information is at least worth considering--particularly if it turns negative over the next several months.

YCI has been at its best in joining bear markets in progress. Most of the time, the indicator is unaffected as stocks decline. Stocks suffer a brief period of losses, YCI remains stable, and stocks then recover. That is the typical pattern. But on occasion, YCI follows the stock market's lead. That is when the real trouble occurs. That's one thing that I will be watching in 2016.


John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.