728x90 AdSpace

Latest News
July 14, 2019

The Mixed Signals from Financial Markets


One common investing adage is “the market is always right.” If you believe in efficient markets, meaning all known information is currently priced in, then you should agree with the adage. But what if the stock market and the bond market are sending different signals? Do you believe the stock market is right or do you listen to the bond market instead? It’s a quandary.

One commonly watched metric in the bond market is the yield curve. The yield curve plots the interest rates for U.S. Treasurys of different maturities. Under normal circumstances, the curve is upward-sloping. The upward slope reflects demands from investors who want higher rates of return for parting with their money over longer periods of time.

Last quarter, the yield curve was inverted. The average second-quarter yield on five-year Treasury notes was 25 basis points (0.25 percentage points) below the average yield of the three-month Treasury bill (2.10% versus 2.35%). The average yield on 10-year Treasury notes was three basis points (0.03 percentage points) below the average yield of the three-month Treasury bill (2.32% versus 2.35%). Put another way, you could have gotten a slightly higher yield by locking up your money for just a few months rather than several years.

Research conducted by Duke University professor Campbell Harvey found that prior yield curve inversions preceded recessions. The average length of lead time between the yield curve inverting on a quarterly basis and recession occurring has been 11 months; it is 12 months if the 2007–2009 global financial crisis is included. So the current inverted yield curve is a concern for those who pay attention to the bond market.

The stock market, on the other hand, is in the midst of a very good year. The S&P 500 index ended the first half of 2019 with an 18.5% gain and nearly closed above 3,000 for the first time today. Such price moves suggest optimism on the part of equity investors about corporate earnings. While current forecasts call for earnings to have declined in the second quarter, analysts’ tendency to underestimate and companies’ tendency to beat the consensus earnings estimates are well-documented. Plus, earnings growth is expected to resume in the third quarter and extend into 2020.

There are certainly arguments to be made for and against the possibility of a recession looming. Last week’s jobs report was good, but the Atlanta Federal Reserve’s GDPNow is now estimating second-quarter GDP growth to be just 1.4%. The Fed is widely expected to cut interest rates, but accommodative monetary policy isn’t keeping Europe’s economy from slowing. The trade war between China and the U.S. could get resolved or it could be dragged on even further. The list certainly could go on.

Also within the realm of possibilities is very slow economic growth but not an outright contraction. While a recession is often thought of as being at least two quarters of declining GDP, this is not how the National Bureau of Economic Research (NBER) defines it. Rather the NBER defines a recession as being “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

Furthermore, while the last two recessions were accompanied by big market drops—the tech bubble burst in 2000 and the global financial crisis of 2007–2009—the next economic slump, whenever it does occur, may be accompanied by a less severe drop in stocks. Most post-World War II bear markets have seen the S&P 500 fall by less than 30% before rebounding. These periods are not fun but financially tolerable for those who don’t panic and have their shorter-term cash needs covered. Plus, to the extent that the stock market is forward-looking, it could start recovering before the economic data points to a recovery being underway.

Then there is the big matter of forecasts. Nobody knows with certainty when the next bear market or recession will occur. Neither expansions nor bull markets die of old age. Unless you have soothsaying ability—and a better crystal ball than me—you run the risk of missing out on further market gains by acting on what you think might happen. If you’re nervous, consider maintaining an ongoing source to fund cash flow needs for the next two to five years. Doing so can help you avoid withdrawing from your portfolio during a downturn and may help you better cope with the uncertainty that always accompanies investing.

The Week Ahead
Dow Jones industrial average components Goldman Sachs Group Inc. (GS), JPMorgan Chase & Co. (JPM), and Johnson & Johnson (JNJ) will report on Tuesday; IBM Corp. (IBM) will report on Wednesday; Microsoft Corp. (MSFT) and UnitedHealth Group (UNH) will report on Thursday; and American Express Co. (AXP) will report on Friday. In total, approximately 60 members of the S&P 500 will report earnings.

The week’s first economic report will be the July Empire State manufacturing survey, released on Monday. Tuesday will feature June retail sales, June import and export prices, June industrial production, May business inventories and the July housing market index. June housing starts and the Federal Reserve’s periodic Beige Book will be released on Wednesday. Thursday will feature the July Philadelphia Fed Business Outlook Survey. The University of Michigan’s preliminary July consumer sentiment survey will be released on Friday.

Three Federal Reserve officials will make public appearances: New York president John Williams on Monday and Thursday and St. Louis president James Bullard and Boston president Eric Rosengren on Friday.

The Treasury Department will auction $14 billion of 10-year inflation-protected securities (TIPS) on Thursday.

Courtesy of Charles Rotblut, CFA is the VP and Editor for American Association of Individual Investors (AAII). Charles is also the author of Better Good than Lucky
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

© EconMatters.com All Rights Reserved | Facebook | Twitter | YouTube | Email Digest

  • Blogger Comments
  • Facebook Comments
Item Reviewed: The Mixed Signals from Financial Markets Rating: 5 Reviewed By: EconMatters