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“Credulity is always greatest in times of calamity” --Charles Mackay
As I sit back and prepare for the new-year, trying to drown out the noise of my giddy and excited houseguests, it reminds me of how difficult it can be to stay focused with the cacophony of information that surrounds me daily. From TV pundits to Internet blogs, I’m overwhelmed by a variety of enticing arguments hoping to sway my opinion about the future direction of the markets. Adrift over the choppy waters, I can’t help but wonder about the direction of the market’s tumultuous waves: will they continue their momentum and propagate to new peaks, or could they come crashing down in a crescendo of destruction over the ignorant and unprepared. Whatever the case, I have no shortage of self-proclaimed gurus, and a never ending stream of arguments to guide me over the uncharted seas. I have a large collection of books I’ve acquired over the years. Some are newly minted and others are yellowing and need to be dusted often. But one section that I can’t help but visit frequently is the business section. I like to remind myself why I believed that the golden 2000’s wouldn’t end till the DJIA hit 36,000, or why the great depression of 2003 would send countless thousands lining up at soup kitchens or jumping out of windows. I remember back in 2003, how certain I was that my shorts would finally hit payday. But then, just as suddenly as the markets tanked, the high flyers came flying back. I downed Zantacs like tic-tacs as I listened to the bubbleheads on CNBC mislead me. I was so certain that the big crash would come any day. There was no possible way that the P/Es could retain those lofty heights. I remember the vindication I felt when one of the high flyers finally reported weakened earnings and a dismal outlook to boot. I also regrettably recall the shell shock I felt when the price of that stock skyrocketed the next morning, in spite of my well thought out short position. Oh, how my stomach ached. Looking back over the years, and reflecting upon how differently things turned out compared to my never ending list of intelligent and thought provoking arguments, I vowed to try to take every argument that comes my way and to look at the information as objectively as possible. And so, that’s my new year’s resolution; to try to look at both sides of the argument and tear apart my old misconceptions about how things should be. I hope to share some of my wisdom along with those who would lend their ears, as I try to weigh some of my objective truths against the shifty soils of reality. There is much reason to expect that the following year will provide an explosive resolution to the ongoing battle between the bears and the bulls. For five years, the NASDAQ has been tightening up like a coiled snake in a basket, ready to unleash it’s fury on those who’ve chosen to divine with the wrong rod. Several new arguments have surfaced about why this time the market will finally melt down; one of the strongest I have seen of late is the inverting of the yield curve. No doubt a very powerful argument, I decided to dig up some charts and tackle the issue with a balanced perspective. Yield Curve and Stock Market Performance: The yield curve is a snapshot of the overall movements of interest rates. A graph of the yield curve typically starts at short term Treasury bond yield maturities and moves out in time towards the 30 yr rates. Economists believe (with good reason) that the different patterns that are created can be used to gauge the current health of the economy as well as it’s future. A good discussion about the types of yield curve patterns can be found at smartmoney.com. One way of visualizing the relation of the yield curve’s impact on the market is to look at snapshots of the yield curve’s behavior over time. The chart in Figure 2 shows that points labeled A, B, and E had a normal and positive slope preceding a lift in the index and periods free from recession. The curve at the point labeled C had a flat characteristic that declined into an inversion. Up until that point, all recessions since 1970 had been preceded by inverted yield curves. This evidence led many economists to be concerned that a recession was highly likely. Although, aside from a minor downturn that followed during the Asian crisis, a recession did not follow. A few years later, however, the inversion at point D (year 2000) did precede a rather severe downturn in the market as well as an eight-month recession that began in March of 2001. Note the downward slope on the yield curve snapshot at point D.
In retrospect, that signal coincided almost perfectly with the breaking of the long up trend support line that ran from about 1995-2000. The FED eased up repeatedly by lowering interest rates and the slope turned positive for a while, until the market picked back up in 2003. That was a good sign to be cautious about the many pessimistic books that were out at the time; predicting dire deflation and an unstoppable collapse in the markets. I can recall how everyone was clinging to the historically overvalued P/E argument (which is very valid and convincing) and waiting for the market to capitulate on high volume before they would even think about entering the markets again. Oddly enough, that turned out to be a short-term bottom, which coincidentally impaled many shorts on its climb back up over the next two years. Which leads us up to the current situation and the dreaded yield curve at point F which has went from flat to momentarily inverted, leading many economists and pundits to wrestle over the implications it has, right about the time that the major indexes have tightened up their triangle patterns to a very sharp point. This type of tightened pattern leading to an inflection point could precede a strong upwards breakaway or a sharp leg back down in the markets. Another way of viewing the dynamics of the yield curve is to look at a plot of the yield curve differential and its impact on the NASDAQ. The yield curve differential shows the difference between short term and log term Treasury bill yields plotted over time. When the curve has a positive slope, the corresponding differential remains above the zero line. This is equivalent to the normal yield curves shown pictorially in Figure 2. A negative or flat yield curve corresponds to the differential plot falling at or below the zero line. Figure 3, displays how the NASDAQ performed over a 30-year period, against the yield curve differential. A curve was fitted to show the NASDAQ’s annualized growth rate of about 11.5% over that period. Note that in the long run, the earlier yield curve inversions did very little damage to the indexes long-term growth curve. However, the relationship between the negative yield differential (inversion) and the NASDAQ performance in 2000 clearly shows how yield curve going negative can precede a very severe drop in the stock market. The NASDAQ lost approximately 80% of its value shortly after the yield curve went negative. In retrospect, one could argue that the NASDAQ had an extreme overshoot, and that the yield curve inversion served as a catalyst to correct that anomaly, before it converged back to the 30 yr. growth rate curve. The final point on the differential curve shows the month just before the yield curve flat lined and inverted (now). The NASDAQ’s behavior seems to show that the system has settled and is tracking the long-term growth curve nicely. Considering that over the past thirty years, yield curve inversions have not caused the NASDAQ to deviate far from it’s underlying growth rate curve, leads me to suspect that the damage that may occur after this most recent yield curve inversion may be moderate rather than extreme. On the other hand it would seem more likely, from a chart and system perspective for the NASDAQ to continue straddling the exponential growth curve upwards.
Real Estate: We can also look at a similar comparison to real estate growth and any related impact from prior periods of yield curve inversions. The shaded blue areas in Figure 4 highlight periods during which the yield curve inverted. During the period shown, national new home sales prices rose at annualized growth rates of 5.6% and 6.1%, for median and average home prices, respectively. Note the hump in the average home sale trend during the mid eighties to early nineties; several analysts have considered this a boom period in homes similar to today. But looking back at the prior periods of yield curve inversion shows no corresponding crash in home sale prices following inversions; rather, they indicate, at worst, moderate resting periods during an upwardly trending market. The sideways action allowed the home prices to continue along their respective growth trend lines similar to the way in which the NASDAQ converged back to its underlying exponential growth curve trend. The period of inversion in the 2000 period shows that home prices continued to rise in spite of the yield curve inversion. Based on the past technical behavior, I would expect the housing boom to possibly exhibit moderate to sideways action while it catches up to its underlying growth rate trend line. This is a far different view in my opinion, than current housing crash pundits are calling for. Note that since these are annual home sales, they do not account for the abnormal booms of some localized housing regions (such as just about any city with the prefix of “san” in California which runs into the 600k + averages). I would suspect that these regions may correct more than the national trend, but not enough to alter the national annualized growth rates dramatically.
What can we conclude from this information? First, I believe that the recent thirty-year chart periods don’t show a great reason to suspect another huge market meltdown in stocks or housing due to the inversion of the yield curve. Secondly, while the annualized growth rate trends in the data presented are slightly higher than longer- term growth rates argued by several economists, based upon the NASDAQ’s prior overshoot, and subsequent settling back to it’s 30YR growth rate curve, I would not expect the market to drastically correct as severely as it did in 2000 and 1929. At worst I could envision possibly another leg back down to 2002 levels and sideways trading similar to Japan’s Nikkei index. This is in stark contrast to many of the popular books that sit on my shelves, collecting dust, and unanimously calling for a national deflationary meltdown in stocks and housing. I think I’ll wait for the next DJIA 100,000 book to come out before I return to my overly bearish perspectives.
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