Investors Can Learn Two Things From The Markets

There are various reasonable reasons, none of which indicate to an easy time for investors.

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A major paradox exists in today's market: Treasurys appear to be predicting a recession, yet equities and corporate bonds are not, despite recent declines. How can such large markets transmit such disparate signals?

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There are multiple reasonable responses, and none of them point to an easy time for investors.

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Begin with the problem. After Federal Reserve Chairman Jerome Powell indicated on Tuesday that greater interest-rate hikes were back on the table, 2-year Treasury rates have risen by more than a full percentage point, the largest disparity since 1981.

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This absurd condition results in no incentive for storing money for a longer period of time, and is referred to as an inverted yield curve, a reference to the form of a yield-to-maturity chart. Many economists regard an inverted yield curve as a reliable warning of an imminent recession, because inversions have always preceded recessions in the past (the 3-month-to-10-year inversion is an even better sign, and is also deeply inverted).

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Risky assets, on the other hand, are not prepared for a downturn. Stocks are cheaper than they were at the start of the year, but they are still more costly than their long-run average. That's not good if the yield curve indicates a recession is on the road, because a recession equals lesser earnings. Stocks should be inexpensive if the recession is factored in.

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Investors have also failed to prepare for a recession by selling cyclical equities that are most susceptible to the economy and shifting into defensive firms with more stable earnings. Cyclicals, which include cars, industrials, banks, and technology firms, are up more than defensives, which include mainstays like utilities and canned food producers. (I exclude oil stocks, as there is disagreement about whether they are cyclical or defensive.)

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Worse, when compared to corporate bonds and cash, the S&P 500 is the most expensive since the dot-com boom on one frequently used metric: future earnings yield, or profits as a proportion of share price. For the riskiness of stocks, there is less extra profit than typical.

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The same is true for trash bonds. They are much lower than at the start of last year, but still significantly higher than the long-run average. The ICE BofA U.S. High Yield index yields around 4 percentage points higher than equivalent-maturity Treasurys, compared to a more than 5 point average since 1996.

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This margin has risen beyond ten percentage points in each of the three recessions since then, as investors have been concerned about defaults. If a recession occurs, there will be significant losses.

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There are three clear methods for reconciling the various messages conveyed by Treasurys and riskier assets.

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The simplest answer is that Treasurys aren't warning of a recession. If investors believe the Fed will decrease rates because inflation will return to pre-recession levels, all pricing is consistent. Short-term Treasury yields indicate that the Fed will continue to raise rates and keep them high, as it has stated. Longer-dated rates signal that the Fed will ultimately reduce them because long-run economic growth will be subpar but not disastrous.

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An inverted yield curve may be the strongest historical indication of a coming recession, but it is not failsafe. It hasn't performed well elsewhere, for example, forecasting eight of the previous four British recessions. It has also sometimes given false alarms in the United States, such as in 1966.

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If the Fed drops rates sufficiently after the economy weakens, it may be possible to avert recession and reverse the curve inversion. Such a soft landing at the conclusion of a series of rate hikes has occurred in the past, in the mid-1980s and mid-1990s, albeit the curve was not inverted beforehand in either case.

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The second explanation is that bond investors are simply better at detecting recessions. According to stereotype, stockholders are optimists looking for good news, whilst bondholders are pessimists waiting for a recession. It's hardly surprising that they usually identify it a year or two before financial markets catch on.

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The reason I don't agree with the argument is because most individuals own both stocks and bonds, and money transfers between the two depending on the outlook. Certainly, equities are more susceptible to idiocy, but outside of bubbles, the general consensus about the economy should be reflected in both Treasurys and stocks.

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The third option is that there is much too much money circulating. Stimulus payouts and Fed bond purchases filled bank accounts and bolstered business profits, and they haven't stopped. Money-market funds have deposited $2.2 trillion in the Fed's reverse-repurchase facility, indicating a surplus of cash.Of course, some was squandered on meme stocks, bitcoin, and exercise bikes, but enough was invested, helping to keep share prices, junk bond prices, and Treasury prices up—and hence rates down.

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Short-term yields are tightly linked to Fed interest rates, so buying Treasurys there has minimal impact. Longer-term yields, on the other hand, should be depressed by the weight of money, and they appear to be: the New York Fed's gauge of the "term premium," or the extra yield offered by Treasurys above (or, as it is now, below) the expected path of future interest rates, has been the lowest over the past year of any time since 1962, barring the pandemic.

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Excess money poured into equities results in a high valuation, even as Wall Street recognizes the potential of a profit blow by decreasing earnings projections. All three explanations are valid, and all three may coexist. High valuations and the potential of recession make it difficult to take risks, but there is also plenty of evidence that the economy is healthy, making betting on an impending recession difficult. Diversify or pile into cash with good rates, ready to take risks again when prices fall.