Does the flattening yield curve predict a bear market in stocks?


Summary:

  1. Based on the yield curve, the bull market in U.S. stocks is unlikely to end in 2018.
  2. Based on the output gap and potential GDP, the U.S. economy is unlikely to enter into a recession for the next 3 years.

Inverted yield curve

A lot of stock market investors have been focusing on the flattening yield curve recently. They think that the bond market leads the U.S. stock market, and that a flattening yield curve is bearish for stocks. They’re wrong.
A flattening yield curve isn’t bearish for the S&P 500. In fact, the opposite is true until the yield curve is inverted.
The yield curve typically flattens in the final 1/3 of the bull market. This means that the U.S. stock market is going up while the yield curve flattens!
HOWEVER, we explained in an earlier post

When the yield curve becomes inverted, it is a great indication that the stock market is about to enter into a significant correction or bear market.
A lot of hedge funds use the 30 year Treasury – 5 year Treasury or the 10 year Treasury – 2 year Treasury. We use the 10 year Treasury –  3 month Treasury Bill rate on the secondary market.
This indicator has never failed before: it has called every bull market’s top, has predicted every recession in the last 67 years, and has never had a false positive.
This is a near perfect indicator, but it is not a part of our model. Sometimes the signal comes out a little too early. Our model can catch the “big rally” and bull market tops with better accuracy.

We’d like to explain this indicator in detail.
Why we use the “10 year – 3 month” and not the “10 year – 2 year”
We’ve tried various combinations of the yield curve (including “30 year – 5 year”), and history shows that a “10 year – 3 month” indicator works best. There’s a logical reason for this.
When a bear market or significant investor is imminent, the smart stock market players will go and buy bonds. They will buy “long term” bonds that will protect their portfolios for a few years (i.e. the “long term”). Since bear markets can last 2-3 years, a 2 year Treasury bond still counts as a “long term” bond in this situation.
Hence, more investors will buy the 2 year bond than the 3 month Treasury bill. That is why the “10 year – 3 month” yield curve is much more responsive (and timely) than the “10 year – 2 year” yield curve to changing economic conditions.
The inverted yield curve leads to an economic recession. An economic recession either coincides with a “significant correction” or a bear market in U.S. equities. Our model knows whether a recession will result in a significant correction or a bear market.
*The yield curve inverts on average 14 months before a recession starts. The U.S. stock market usually tops after the economy shows cracks but before a recession begins.
The current yield curve
The 10 year yield is 1.03% above the 3 month Treasury rate right now. At the rate that the U.S. yield curve is flattening right now, it will be at least mid-2018 before the yield curve inverts. And this assumes that the yield curve flattens nonstop, which is an unlikely scenario. I expect the yield curve to widen a little before it continues to flatten. This means that it’ll take even longer for the curve to invert.
This fits with our model‘s prediction that this bull market has at least 1-2 years left.

Inverted yield curve’s historical cases

Let’s look at history to see what happens to the U.S. stock market after the yield curve inverts.
January 12, 1966
The yield curve inverted in mid-January 1966, one month before the S&P 500 topped in mid-February. Then the S&P 500 made a 23.6% significant correction. Our model predicted this significant correction without using the yield inversion indicator.

December 19, 1968
The yield curve became inverted right around the top of the bull market.

June 1, 1973
The yield curve inverted on June 1, 1973, which is after the bull market topped. This bear market was a little different. Based on our model’s initial prediction, this was supposed to be a significant correction and not a bear market. But as the data changed, our model realized that this was actually a bear market.
The S&P topped in mid-January 1973.

November 2, 1978
This signal came out too early. The yield curve became inverted in November 1978, but the next significant correction began in February 1980!

October 27, 1980
The yield curve became inverted less than a month before the S&P began a significant correction in late-November 1980.
May 31, 1989
Once again, the yield curve inverted way too early. The next significant correction began in July 1990.

July 28, 2000
Yes, the yield curve did invert after the S&P topped in March 2000. However, the S&P made a massive flat top. It just so happened that the exact top was in March. The S&P almost made a new high in early-September 2000.
In addition, the 1990s bull market led to a bubble of epic proportions. Our model told us to switch to 100% cash mid-1999, almost a year before the bull market topped.

August 2, 2006
The yield curve became inverted in August 2006 because savvy investors recognized that the U.S. economy was going down.
However, this was more than 1 year before the bull market topped in October 2007. Investors who sat on the sidelines would have missed out on huge profits.

Yield curve conclusion

You can see that the results vary widely. Based on this indicator, the bull market can end immediately after the yield curve inverts, or it can end more than 1 year after the yield curve inverts! With the 10 year – 3 month curve still far from being inverted, I am not concerned about this indicator (yet).

Output gap

The output gap is an economics concept that states:

The output gap is the difference between actual and potential economic output. “Potential output” (aka potential GDP) is a number that economists guesstimate. The economy performs below potential output most of the time. Hence, there is an output gap most the time, except when the economy is on fire.

Here is an estimate of the output gap right now.

As you can see, the U.S. economy just went from being below potential output to being above potential output.
In the past 3 economic expansions (1980s, 1980s, and 2000s), it has taken an average of 3.33 years for the economy to go from being above potential output to a recession. Of course, this isn’t a large sample size. But it results in the same conclusion as the yield curve, which our model confirms:

The current bull market still has at least 1-2 years left. Emphasis on “at least”.

4 comments add yours

  1. Those theories from the past are outdated and meaningless. All you have to know is the stock market today is the most overvalued of all time and the $64,000 question is when are the central bankers going to pull the plug and let the market crash 75 to 90 percent?

    • It isn’t the most overvalued of all time. See the Tobin’s Q chart. And the Fed stopped QE years ago. They are on a normal rate hike path.

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