By CCN.com: The Dow Jones fell 800 points on Wednesday, as a major recession indicator – the yield curve inversion – clicked on, spooking investors.
Yet this recession indicator isn’t always correct, and the S&P 500 and the stock market have traditionally provided impressive returns, at least in the short-term, following its appearance.
The dreaded inverted yield curve
This indicator is known as an inversion of the yield curve. Ed Butowsky, managing partner of Chapwood Capital Investment Management, explains to CCN.com that a yield inversion means that:
“Interest rates on short-term bonds turn higher than the interest rates paid by long-term bonds. That usually means investors are selling stocks and buying bonds because they’re losing confidence in the economy.”
In this case, the short-term bonds are represented by 2-year Treasury bonds and long-term bonds are represented by the 10-year bonds.
Yet Butowsky says that this “doesn’t guarantee a recession will occur, nor does it guarantee that the stock market has begun a prolonged period of decline”. A short period of inversion may prove to be a market decline head-fake.
It all depends on how long this inversion lasts. The longer it goes on, the less confidence investors have in the stock market.
Recession length is a critical metric
On average, recessions typically appear 22 months after an inverted yield curve appears.
Yet the S&P 500 returns over certain periods do not always correlate with an inverted yield curve.
This next chart shows that the S&P 500 does rather well over several time periods following an inverted yield curve.
Here’s another chart that seems to suggest the same correlation.
Don’t be fooled — bear markets can lurk behind inverted curves
Yet these charts do not tell the entire story.
In four out of five of these cases, the S&P 500 suffered significant declines beyond the three-year date of the initial inversion.
The S&P 500 fell into a bear market between November 1980 in August 1982, losing a total of 28 percent during that period. This was also after the disastrous Jimmy Carter administration, where the Federal Reserve was forced to raise interest rates to nearly 20 percent, which indeed pushed the economy into a recession.
Following the 1998 inversion, the market fell into the dot-com bear market, driving the S&P 500 down by 49 percent.
Finally, we all know what happened after the 2005 inversion. The mortgage crisis hit, and the S&P 500 went into a devastating bear market in which it lost 56 percent of its value, between October 2007 and March 2009.
Disclaimer: This article is intended for informational purposes only and should not be taken as investment advice.