The word recession scares most investors since it inevitably means pain for stocks. Therefore, investors are always looking for a signal that the global and US economy is slowing down and a recession is coming. One significant indicator is the yield curve, the plot of interest rates for US Treasury Bills and Bonds. The yield curve inverted this past week, causing worry for many investors.
Bear in mind though it does not really matter much for buy-and-hold investors. If your investing horizon is in years, a recession will be a relatively short period because stocks tend to rise in price over time.
According to the National Bureau of Economic Research (NBER), there have been 13 recessions since WWII. The average one lasted about 10.3 months, while the average growth period lasted 64.2 months. However, the average recession is generally getting shorter, and the most recent one, from February to April 2020, during the start of the COVID-19 pandemic, was a short two months.
So, what does an inverted yield curve mean, and is it really a recession signal?
The Yield Curve Inverted
An inverted yield curve has marked every recession. However, the reverse is not 100% true; an inverted yield curve does not always signal an impending recession. This fact makes the yield curve an excellent but imperfect indicator of recessions—more on this fact below.
The table shows the interest rates for US Treasuries. The 2-year bond interest rate is higher than the 10-year this past week, marking the first inversion since 2019. In addition, the 5-year bond interest rate is higher than the 10-year last week, marking the first inversion since 2006.
The chart below shows the inversion, also referred to as the negative spread.
What Does It Mean?
When the yield curve inverts, investors sell short-dated T-bills and bonds in favor of longer-dated ones. They do this because they are concerned about the near-term economy compared to the long-term economy. Investors are expecting interest rates and higher inflation in 2-years than in 10-years. In this case, it may indicate the expected effects of inflation, interest rate hikes by the US Federal Reserve, and the impact of the conflict in Ukraine.
However, an inverted yield curve is not always a recession signal.
The predictive power of inverted yield curves for recessions is not foolproof, but they are still excellent. In the past 40 years, the 2-year and 10-year yield curves have only been inverted 7% of the time. It has predicted six recessions since 1978 with only one false positive. Reportedly, there is more than a 66% chance of a recession in the next year and a 98% change in the next two years. However, the predictive power is reportedly better when the 3-month and 10-year US Treasury inverts.
However, an inverted yield curve does not predict precisely when a recession will occur. The time expired before the start of a recession has varied from six to 24 months.
What Happened to Stocks?
Stocks can perform poorly after an inverted yield curve, but not always. For instance, stocks returned 11% on average after an inverted yield curve.
However, they do poorly during a recession, whether for long or short periods. For instance, during the COVID-19 pandemic recession, the S&P 500 Index was down about (-9.2%) from February to April 2020. In another example, according to Portfolio Insight*, stocks were down roughly (-35.5%) during the 18 months of the Great Recession.
However, the critical point is that stocks recovered and eventually surpassed their pre-recession high. Sometimes, the recovery takes time.
Final Thoughts on Recession Signal
Overall, investors may be asking themselves what to do?
The main point is that inversion of the yield curve is an excellent but not infallible signal for a future recession. The US economy is strong today with low unemployment, rising home prices, creating jobs, etc. Despite rising interest rates, they are still relatively low. Furthermore, the US Federal Reserve could quickly stop rate increases or start rebuying bonds flooding the economy with money again.
As buy-and-hold investors, most should take the time to review their portfolios and adjust as needed. If you picked your stocks wisely they might do well during the a recession. Recessions occur, stock prices come down, but they eventually recover based on history.
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The Stock of the Week
Today we run a screener on StockRover to identify undervalued companies with a safe but reasonably high dividend yield that is growing and a net cash position on the balance sheet. We look at the following screener criteria:
- Dividend yield > 3%
- Payout ratio < 50%
- P/E ratio < 20X
- Net debt < $0 (meaning cash position)
- Divided growth > 10 years
The result is only ten stocks. It consists mainly of banks and insurance companies with cash-heavy positions and low price-to-earnings (P/E) ratios. However, the list also includes T. Rowe Price (TROW), a Dividend Aristocrat.
The screenshot below is from Stock Rover*.
Dividend Increases and Reinstatements
Dividend Cuts and Suspensions List
The dividend cuts and suspensions list was most recently updated at the end of March 2022. As a result, the number of companies on the list has risen to 548. Thus, well over 10% of companies that pay dividends have cut or suspended them since the start of the COVID-19 pandemic. The list is updated monthly.
Four new additions indicate companies are experiencing solid profits and cash flow in March.
The new addition was Orchid Capital (ORC), Lument Financial Trust (LFT), 360 Digit Tech (QFIN), and James River Group Holdings (JRVR).
Dow Jones Industrial Averages (DJIA): 34,818 (-0.12%)
NASDAQ: 14,169 (+0.65%)
S&P 500: 4,543 (+0.06%)
The S&P 500 is trading at a price-to-earnings ratio of 25.92X, and the Schiller P/E Ratio is about 36.83X. Note that the long-term means of these two ratios are 16.0X and 16.9X, respectively.
The market is still overvalued despite the recent market correction and rebound. Earnings multiples more than 30X are overvalued based on historical data.
S&P 500 PE Ratio History
Shiller PE Ratio History
Stock Market Volatility – CBOE VIX
This past week, the CBOE VIX measuring volatility was down about 1.2 points to 19.63. The long-term average is approximately 19 to 20. The CBOE VIX measures the stock market’s expectation of volatility based on S&P 500 index options. It is commonly referred to as the fear index.
The two yield curves shown here are the 10-year US Treasury Bond minus the 3-month US Treasury Bill from the NY York Fed and the 10-year US Treasury Bond minus the 2-year US Treasury Bond from the St. Louis Fed.
Inversion of the yield curve has been increasingly viewed as a leading indicator of recessions about two to six quarters ahead, according to the NY Fed. The higher the spread between the two interest rates, the higher the probability of a recession.
The US Bureau of Labor Statistics Job Openings and Labor Turnover Survey, or JOLTS, reported 11.266 million job openings as of the last day of February; Industries contributing to the decrease in job openings include finance and insurance (-63,000) and non-durable goods manufacturers (-39,000). On the other hand, job openings increased in the arts and entertainment (+32,000), education services (+26,000), and the federal government (+23,000). The number of people who voluntarily left their jobs was little changed at 4.4M. That marks the ninth consecutive month that more than 4M people quit or changed their positions.
The Bureau of Economic Analysis’ third estimate of Q4 2021 gross domestic product (GDP) growth reported 6.9%, well above the 2.3% pace set in the third quarter and down slightly over the second estimate of 7.0%. For all of 2021, the nation’s GDP grew by 5.7%, the most robust pace since 1984. The acceleration in real GDP was driven by increases in private inventory investment, exports, PCE, and nonresidential fixed investment, partly offset by decreases in federal, state, and local government spending.
The US Bureau of Labor Statistics reported 431,000 jobs were added in March, as the unemployment rate edged down to 3.6%, with 6.0M unemployed. February 2020’s pre-pandemic reading was 3.5%, with 5.7M unemployed. Payrolls were revised for January (+23,000) and February (+72,000). The March increase in payrolls was broad, with leisure and hospitality (+112K), professional and business services (+102K), retail trade (+49K), and manufacturing (+38K) all contributing. Employment in professional and business services and retail trade is tracking above pre-pandemic levels, while leisure, hospitality, and manufacturing are still below pre-pandemic levels.
Thanks for reading Recession Signal – Week in Review!
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Prakash Kolli is the founder of the Dividend Power site. He is a self-taught investor, analyst, and writer on dividend growth stocks and financial independence. His writings can be found on Seeking Alpha, InvestorPlace, Business Insider, Nasdaq, TalkMarkets, ValueWalk, The Money Show, Forbes, Yahoo Finance, and leading financial sites. In addition, he is part of the Portfolio Insight and Sure Dividend teams. He was recently in the top 1.0% and 100 (73 out of over 13,450) financial bloggers, as tracked by TipRanks (an independent analyst tracking site) for his articles on Seeking Alpha.