Serious Money: Investors shouldn't ignore historical evidence that downward yield curve precedes economic slowdown, writes Charlie Fell
Financial markets of late have been characterised by a gradual improvement in sentiment. The Dow has advanced 8 per cent from its recent lows in June and is just a few good sessions away from the all-time high registered six years ago. Volatility has returned to the historically low levels that prevailed before the sell-off in May. Lower energy prices, a decline in geopolitical tensions and more importantly, the overwhelming belief that a soft economic landing is at hand in the US, have all helped drive stock markets higher. The bulls point to the possible easing of monetary policy by the Federal Reserve as early as February, alongside the foolproof presidential cycle, as reasons to accumulate stocks. Are investors being too complacent or is this the calm before the storm?
The election cycle, whereby stock prices typically mark an important low before the mid-term elections, is one of the many puzzles that has confounded academics down the years. Stock prices are supposed to be random, exhibiting no predictable pattern. However, the average gain in the Dow from the mid-term low to the election-year high has been more than 50 per cent over the past 10 presidential cycles and has never been less than 30 per cent. The administration and the Federal Reserve have managed the economic cycle effectively so that a recessionary trough or growth slowdown occurs during the second year of the president's four-year term, only to accelerate into the third and final year in office.
Unsurprisingly, a bear market and its subsequent bottom accompany the poor mid-term economic growth. Indeed, an important market low, which typically occurs this time of the year, has been a feature of eight of the past 10 presidential cycles. The only exceptions are 1986 and 1994. Investors have not endured a major market setback during the current cycle. Indeed, this is the second longest advance without a market drop of 10 per cent. Do the previous exceptions provide any clues?
The post-1986 period was followed by "Black Monday" the next year, when stock prices dropped by an alarming 22 per cent in a single day.
Interestingly, this was the last time a new chairman took the helm at the Federal Reserve and trade frictions were, as today, running high. However, that is where the similarities end. Long-term interest rates are just 5 per cent today, roughly half the level that prevailed in 1987.
The latter period was followed by the late-1990s boom in stock prices. Similarities between then and now are few. Pretax corporate profits as a percentage of gross domestic product (GDP) were five points lower than today, while the administration's budgetary position was in excellent shape. The stock market appeared attractive given the strong outlook for corporate earnings. Perhaps the presidential cycle's winning streak is set to come to an end.
Conventional wisdom holds that stock prices struggle during a bout of monetary tightening and resume their upward march when the sequence of interest rate hikes come to an end. However, this thesis is not supported by the historical data. Indeed, the stock market typically moves higher as policy is tightened and struggles once the peak in rates has been reached until policy is eased. Prices typically decline during this phase and the drop is usually accompanied by an increase in volatility.
The historical evidence suggests the coast is not yet clear for investors to accumulate stocks. This view of the market is supported by the yield curve, which graphs the relationship between interest rates and the term to maturity of identical fixed income securities. Long-term interest rates are currently below short rates - the curve is downward sloping, a condition which typically occurs 12 to 18 months before a recession. A downward sloping curve has preceded every economic downturn and the accompanying decline in corporate profits in the past 40 years.
Numerous explanations have been given as to why the yield curve can be ignored, and every time it slopes downward, market analysts and economists rush to dismiss its relevance. This has proved costly to investors. The Wall Street Journal surveyed 19 economists in May 1990, and not one expected a recession for the next two years - the economic expansion peaked in July and a bear market followed. Current analyst estimates call for a 10 per cent increase in profits next year, which looks optimistic given the historic relationships and record margins.
The recent market advance has been unconvincing given that it has occurred on the back of relatively low volume. Investors are convinced that the current economic slowdown is nothing more than a soft patch and that the expansion will be sustained as the Federal Reserve rides to the rescue early next year. The historic evidence suggests otherwise.
Central bankers may be in no hurry to reduce interest rates as it may heighten inflationary pressures via a lower dollar. For investors it's time to abandon cyclical stocks in the industrial and commodity arenas and emphasise traditional growth defensives such as pharmaceuticals and consumer brands.
