Should I Panic Yet?

Stock market anxiety has suddenly gone mainstream. I was at a birthday party and a friend came up to me and whispered, “Hey I hate to bother you with work stuff, but should I be worried about the inverted yield curve?” What the what!?! That came out of left field. Who put that idea into his head? Why has the stock market captured people’s imagination recently? Why is the financial media sounding the gloom-and-doom alarms? The timing is a bit odd and surprising, since we’re only about 2% below the stock market’s all-time highs—and that was just a few weeks ago! You would think people would have been freaking out more in October, November and December of last year when the stock market was dropping 20% from peak to trough. I didn’t hear much about it then. What gives? Why now?

Granted there’s a lot to worry about. There are trade wars, the Brexit saga and signs of slowing growth in Europe and Asia. And there’s the “inverted yield curve,” which seems to be the buzzword du jour. It describes an environment in which the interest rates on short-term government bonds are higher than the rates on long-term bonds. In a "normal" yield curve, you'd generally expect a higher interest rate if you tie up your money longer so would receive a higher interest rate on a long-term bond than a short-term one.

Short-term rates are typically influenced heavily by Federal Reserve policy while long-term rates are driven more by market expectations. Long-term rates have been declining for several months, reflecting expectations for slower economic growth and lower inflation. The financial media has been especially focused on the spread between the 10-year and 2-year treasury bonds, which has been a pretty good predictor of the last few recessions (see chart below).

As if often the case, markets have moved faster than policy makers and therefore long-term rates have moved downward more quickly than short-term rates. The Fed has begun to lower the fed funds rate, though, with further cuts expected over the next few months. It's quite possible there will be a recession—a temporary decline in GDP—sometime over the next couple years. But even if we accept that possibility, we don't know when, we don't know how deep and we don't know how it will impact the stock and bond markets.

10-2 yield inversion.jpg

Perhaps the current media interest in the yield curve and stock market is related to the 2020 Presidential elections, as the economy could influence the election outcome and the elections could influence the economic outlook. The stakes are higher right now and articles about recessions are a little more attention-grabbing than usual. With the current administration, we also have to monitor the Volfefe Index of presidential tweets (see chart below). Stock market volatility is indeed correlated with the volume of oval office tweets. Markets like stability. We don’t have that.


The bigger picture issue that the stock market seems to be trying to decipher is the impact of growing populism and nationalism across the globe. In 2004, Thomas Barnett published the book The Pentagon's New Map: War and Peace in the Twenty-First Century, which resonated with me as I tried to understand the 9/11 attacks and subsequent wars in Iraq and Afghanistan. In the book, Barnett introduced the concept of the Functioning Core and the Non-Integrated Gap, which echoed concepts in Thomas Friedman’s 1999 book The Lexus and the Olive Tree: Understanding Globalization. The basic thesis, in both books, is that there are developed nations thriving and connecting through globalization and there are less developed parts of the world that have been left behind.

It probably should have been obvious to me at the time, but that same “haves-and-have-nots” dynamic applies within borders just as well as it does across borders. In many countries, there are educated “elites” benefiting from automation and globalization and working-class folks that are struggling to adapt. In a recent Ipsos poll of 18,000 people in 27 countries, 70% said “the economy is rigged to favor the rich and powerful” and 64% said “their country needs a strong leader to take it back from the rich and powerful.” We see this populist sentiment across the world and politicians are channeling that anger into anti-migration, anti-elite, anti-science and anti-trade policies.

Stocks represent ownership in companies and the value of stocks is based on future earnings. The global stock market is trying to determine if we’re entering an era of decreasing global cooperation, less connectedness and more insular attitudes. If so, could the global economy and thus corporate earnings grow more slowly? And even more troubling, could it make climate change more difficult to counter and war more likely? The market will probably remain volatile as it wrestles with these issues.

You get returns on stock ownership because of the risk, not despite the risk. It’s the inherent and persistent uncertainty in the stock market that generates higher returns than more predictable investments like bonds. There’s always a lot to worry about. The modern stock market has been around for more than 120 years, through political upheaval, scandals, wars, depressions and discontent. There have been short- and intermediate-term bumps in the road, but the Dow Jones Industrial Average has gone from 40 to 27,000 (see chart below). In the long-run, companies figure out a way to grow revenue and generate profits.

Dow Jones Historical Trends chart.jpg

I read a quote on Twitter recently from @verdadcap that “investing isn’t a game of analysis but rather a game of meta-analysis,” which was in response to another great quote from @HayekAndKeynes: “If you have views on the future but it’s reflected in price, being right about the future won’t make any outsized returns.” To do better than the market, you must be right on fundamentals AND the market has to be “wrong” on those same fundamentals—in other words if you think you can profitably trade on recession expectations you have to believe that the stock and bond markets aren’t adequately reflecting the potential for a recession. According to an ABC News/Washington Post poll released yesterday, 60% of Americans believe a recession is likely to occur in 2020. It’s become a consensus view.

If you knew a recession was coming and the market didn’t, you could “protect” your capital by moving your money into cash, bonds and certain alternative investments. You don’t know more than the market, though. And you would have to be right twice. You must be right on the timing of moving into recession-proof investments and you have to be right on the timing of getting back into the stock market. That’s a tall order.

If your nervous about the economy and the stock market what should you do? Probably nothing. Make sure you’re in age-appropriate stock/bond allocations, sure. Focus on optimizing your savings rate, definitely. Not much else though. We believe it's counter-productive to think about "what ifs" and instead would encourage you to "set it and forget it." Automate your investments, be consistent and turn off CNBC, ha!

Tim Quillin