What dangers does the inverted yield curve pose to the stock market and what should you be doing with your investment portfolio? Read on and I’ll shed light on this issue.

An inverted yield curve is a problem, right? Just look at some headlines and it seems self-evident. 

•  Are We Near a Recession? The Godfather of the Inverted Yield Curve Says It’s “Code Red”  Fortune Magazine 9/20/2019 by Lucinda Shen
•  Recession Watch: What Is An Inverted Yield Curve and Why Does it Matter?  Washington Post 8/14/2019 by Jonelle Marte 
• The “Inverted Yield Curve” Is Signaling a Recession; These Stocks Could Weather the Storm  The Motley Fool 8/23/2019 by Beth McKenna 

Reading some of these headlines, I’d be tempted to unplug and head for the bunker. But the real question everyone should be asking is as follows: Does an inverted yield curve tell investors anything meaningful about the timing and direction of equity market moves? In other words, should you be making adjustments in your investment strategy because of the prospect of an inverted yield curve?

Let’s solve this mystery by looking at history and getting some color from my five-year-old son. He is fascinated by the show “Treehouse Detectives,” whose main character is a cute little bear, Toby. Toby and his friends are detectives who look at facts to gain insight into the world — which is, in fact, exactly the kind of process I use when developing investment strategies for my clients. The difference is that I look to the research of Nobel Prize-winning economists and academic leaders in finance instead of little fuzzy bears. But the process is valid for either scenario. My son even anointed himself with a detective nom de guerre: “Detective Figure Things Out.” So, let’s figure things out and see if an inverted yield curve can tell you anything meaningful about the timing and direction of the equity markets.

By the way, once Toby and friends have solved their mystery, their mantra is This Mystery Is History. For the inverted yield curve mystery, we’ll change the meaning of the phrase slightly in that the mystery won’t be fully solved, but insight into the mystery can be gained by looking at history.

Let’s get right to the point. I’ll bullet the salient points of a study by Dimensional Fund Advisors, “The Flat Out Truth,” which looked at the relationship between U.S. stock market performance and inverted yield curves, in addition to selected developed international country stock market performance following yield curve inversions. The study quotes are italicized with my comments following and I encourage you to look at the data and disclosure from the study for further insight.

• U.S. Data & Conclusions: “The small number of US yield curve inversions over the last 40 years makes it challenging to draw strong conclusions about the effect on stock market performance.” 
  • Going back to June 1976 through September 2018, there have only been four periods of yield curve inversion to study. Now I’m no statistician, but I played one in my MBA program, and I’m pretty certain that having only four data points is not enough to draw any conclusions. Moral of the story: If you hear or read about anyone making definitive statements about what the stock market is going to do based on the history of yield curve inversions in the U.S., be skeptical. Very, very skeptical. The irony is, they may be right. We just don’t have enough information to say either way. 
  • So, not enough information in U.S. market history? Then, let’s look at select developed markets to get some more data points, but first…
  • What is very clear in the data is that given time, the S&P 500 had positive returns through all four inverted yield curve periods, with $1,000 invested in June 1976 turning into $90,000 in September 2018. 
• Selected Developed Country Data and Conclusions: “Though the data set is limited, an analysis of yield curve inversions in five major developed countries shows that an inversion may not be a reliable indicator of stock market downturns.”
  • Including Australia, Germany, Japan, the United Kingdom and Japan with the U.S. increased the researchers’ data set to 14 yield inversion periods.
  • Still, no reliable conclusions.
  • But, clearly, “In 10 out of 14 cases of inversion, local investors would have had positive returns investing in their home markets after 36 months.”  
  • So, in 71 percent of the cases, local investors would have experienced a positive return after 36 months of an inverted yield curve. Interestingly, this is about the same chance of experiencing a positive return regardless of what the yield curve was doing. (See note 2 in the study for details.)

Back to the essential mystery: “Does an inverted yield curve tell investors anything meaningful about the timing and direction of equity market moves?”

Answer: No. 

What should you not do? React haphazardly or over-exuberantly to the fears or optimism headlines and talking heads use to gain an audience.  

What should you do? Develop a long-term plan that will reap rewards through all market cycles and economic nuances like inverted yield curves. 

In the words of the infamous “Detective Figure Things Out,” this mystery is history.

Past performance is not a guarantee of future results. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. Investors should talk to their financial advisor prior to making any investment decision.

Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Diversification does not eliminate the risk of market loss.

All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer solicitation, recommendation, or endorsement of any particular security, products, or services.