No, it's not the latest in the line of awful post-apocalyptic Shailene Woodley movies; it's the 2-10 yield curve! In simple terms, 2 year U.S. treasuries are now yielding the same as or slightly higher than 10 year treasuries. At the time of writing, the rates are 1.526% and 1.516% respectively. 


Yes, it basically means that the yield of 10 year bonds, which were threatening to break out above 3.25% just under a year ago (thus scaring the markets, as higher rates would slow economic growth and reduce the attractiveness of common stock dividends at around 2%), are now yielding a pathetic one and a half percent. So much money has piled into safe U.S. treasuries that an owner of a 10 year--or even a 30 year-- bond is content to earn a yield to maturity of around half the historical rate of inflation. That's how crazy and over-bought the bond market has become now. If you bought the TLT (twenty year U.S. treasury-bond ETF) at its lows last fall, you would be looking at around a 30% return right now, thanks to declining rates. A typical aggregate bond ETF meanwhile, like ZAG which has a more diverse mix and overall shorter average term to maturity, still did 8% over that same time period.


If overvalued investments scare you, then I think a 30 year U.S. T-bond yielding just over 2% should scare the bejeezus out of you; not stocks trading at less than 20 times earnings while also yielding 2% in dividends, as they are in the U.S. currently! To a German investor, is buying a 30 year Bund yielding -0.19% (at time of writing) smarter than buying German stocks trading at just 13x earnings and yielding dividends at almost 3% on average???



So anyway, what does the yield curve inversion mean? This has already been discussed by many this past month, even by the clowns on late-night talk shows. I'll let you Google it to get the full range of opinions. Tony Dwyer gives a good illustration in the video above as well, plus his take. Basically, it can mean whatever the person writing about it wants it to mean. If you want to scare your readers and attract clicks, as is the prerogative for the financial noise networks: winter is coming. If you actually have studied some market history though, you'd know that if the YCI has any precedent, it's that a) it has predicted recessions fairly accurately, but b) those recessions tend to be 1-2 years out, and c) the stock markets have historically returned above average returns over the period from the YCI to the actual start of a recession. 


Here's where I'm going to split from the theses of Dwyer et al, or maybe at least add some additional considerations (I like Tony, and hope he's right!). The current YCI might not predict anything at all. What I mean is I don't think it can predict an upcoming recession any more than it can predict similar strong short-term stock market returns this time around. Simply (and I know how often people are made to eat these words, Tony even refutes them in the above video) this time is different. To illustrate, check out the table below that I crudely threw together on Excel one morning. I'll apologize that I spent more time looking up the numbers on the St. Louis and Minneapolis Fed websites than on formatting.



The colors of the cells are meant to indicate the general direction of each respective rate in the historical YCI months, with white indicating relatively flat trends. The darker the green, the faster rates were rising. These are all the previous YCI occurrences that are referred to in all the data. Unfortunately, I think in 1968 and 1973 2 year T-notes weren't a thing, but we can see that inflation was high and long-term yields were rising, so we must assume short-term yields were rising faster.


That's the thing. Well, 2 things in each past occurrence: Inflation was high. 2 year yields were rising faster than 10 year yields.


What we have today is completely different and thus we can infer absolutely nothing from it as there never was a precedent in "modern" financial history. There never was a time (except maybe pre-1950, maybe during the Great Depression) when a YCI happened during a period of low inflation, caused by the 10 year rate falling faster than the 2 year rate. Previous YCIs all occurred during periods of high and rising inflation (recession-causing inflation) where the Federal Reserve caused short-term rates to rise faster due to expeditious rate-hiking.


Today we have low inflation which is great for the economy overall, at least it poses no roadblock to further growth. We have a fairly accommodative Fed, with the Fed Funds Rate at just over 2%, and such a massive supply of money available for borrowing that the whole yield curve up to 30 years is lower than the FFR. Corporations with strong credit ratings can borrow at just slightly (around 2%) higher than these ultra-low rates, those with bad credit can still borrow at single-digit rates, and the American consumer can now mortgage their home for 30 years at 3.8%. In Canada too, 5 year mortgage rates are readily available at rates below 3%. NONE OF THIS IS BAD FOR THE ECONOMY!!!



The Evidence Speaks for Itself


All that said, none of it matters anyway.


The part of the tables above that I want to direct everyone's attention to month in and month out isn't the top part, with all the year to date returns, but rather the "Potential Drawdown Table" at the bottom. This is meant to show how much (or how little) the markets have drawn down below their previous all-time highs, and how much further they can fall to reach very normal drawdown levels which they've reached many times in the past.


Someone will always have an opinion on where the markets or the global economy are going. In fact, many people provide such opinions, yet no one can truly predict future movements of the markets; retail investors or portfolio managers like me even less so than people who study the markets full-time. As an evidence-based investor, I don't believe that opinions should factor into my clients' investment strategy. Financial plans drive investment strategy; as do facts and evidence.


I'm 38 years old, and on the day of my birth the S&P 500 had a value of 134 and in the year prior paid out $6.44 in dividends for each S&P 500 "unit" purchased. When I was 6 years old there was a massive "crash" in the market and it hit a low that year of 221, while paying $9.17 in dividends.


When I was in university the technology bubble burst, and literally two days after I moved to Boston to finish my degree at Northeastern, 9/11 happened, then later the implosions of Enron and Worldcom led to further declines (3 straight years of negative markets). The S&P 500 hit a low of 768 in October of 2002 and paid out $15.96 in dividends that year.


At the start of my career, the financial crisis happened and the S&P 500 briefly hit lows even lower than in 2002 and in 2009 paid out $21.97 in dividends. Another bear market in 2011 saw it dip to 1114 while paying out $26.53 in dividends.


Let's assume we have yet another bear market--a repeat of last fall--and the S&P 500 dips to the -20% mark off my table above. 2422 is more than double its lows from just 8 years ago and it's higher than the all-time high from just a little over two years ago. It's a whole 1000 points more than the highs from 2011/2012. Its current annual dividend payout of $55 is also more than double what was being paid out in 2011 and roughly half the entire value of the S&P 500 (at its lows) when I was born.


So that's the evidence that guides my investment strategy. Over my lifetime the markets have gone up, the S&P 500 having multiplied its value 20-fold and its dividend 9-fold. This rise reflects growth in the global population from 4.5 billion to 7.5 billion, going on 10 billion. It reflects the tremendous achievements in efficiency through computing and automation. It reflects a world that is developing rapidly, with a booming middle class and more than half the global population now living above the poverty line. The wars against disease, famine, and extreme poverty are being won, gradually, and a majority of the world's population now lives in mostly free-market mostly democratic countries. The rise in the markets also reflects the growing fortunes of corporations, who generously share their profits with shareholders through rising dividends and share buybacks. And yes, it also reflects some inflation too, which is a good thing, because as you can see above, bonds and GICs today don't.


That's all there is to it! My strategy is pretty simple: own the great companies of North America and the world. I expect to be enjoying retirement 38 years from now, and if the trends continue, it's not unrealistic to expect the S&P 500 at that time to have a value of between 20,000 and 50,000 (inflated future dollars), while paying an annual dividend greater than what its full value was when I was born. And it'll continue to do so throughout your and my retirements.


In the words of Jack Bogle...


Tweets and Articles for August


Whenever I read something good, I tweet it out from @CGWM_Muhs. Follow me on Twitter if you want live updates of what I'm reading. For those who don't have the time for Twitter, a short list of some of the best stuff I read below.


More Stuff


Capital Group's Mid-Year Outlook CLICK HERE


RBC Global Asset Management's One Minute Market Update for Summer 2019 CLICK HERE

RBCGAM's One Minute Market Update is a short quarterly overview of the markets. What I especially like is their "Fair value range" charts on the right side, taking very long term views of various markets and where stocks are trading relative to long-term fair value.


JP Morgan's latest Guide to the Markets CLICK HERE

This 60+ page slideshow is chock full of charts, facts and figures, that give you pretty much everything about everything you could possibly want to know about the economy and markets. Want to know how U.S. stock valuations compare either historically or with the rest of the world? Want to know how much the U.S. government is borrowing? You'll find it all here.

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