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- Cam Harvey — partner and senior advisor at Research Affiliates — ran an analysis averaging stock-market returns for the three years preceding the past seven yield curve inversions. He also did the same for the three-year periods afterwards.
- An inversion of the two- and 10-year yield curve has preceded every recession since 1950.
- Harvey advocates for an allocation to value stocks after such an inversion, and backs up his call with hard data.
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It’s a scary time for investors.
Trade wars, political turmoil, and slowing global growth have all suppressed optimism across the market. And now the bond market has thrown investors yet another hurdle to clear: a yield-curve inversion.
Two-year US Treasurys have yielded more than their 10-year counterparts on multiple occasions over the past several days, breaking an important threshold that many investors use as a barometer for growth prospects within the US.
Investors know such an inversion has preceded every single economic recession since 1950, and major indices have responded negatively to each instance.
Even if the curve uninverts, many think the damage has already been done — and the analysis they’ve brought forth spells bad news for equities going forward.
"One thing that’s clear is that since the 1960’s we’ve had seven recessions," Cam Harvey, partner and senior advisor at Research Affiliates, said in a recent Conversations episode posted to the firm’s website. "And we’ve had seven yield-curve inversions before each of those recessions, so this is a pretty reliable leading indicator."
Bank of America currently has the odds pegged at about a 1-and-3 chance over the next 12 months, saying "we are worried."
But what does this mean for stocks? How bad can things get?
Well, Harvey has crunched the numbers — and the results aren’t pretty.
Below is the cumulative market excess return for the average of the past seven yield curve inversions since 1960.
Research Affiliates
In his analysis, Harvey looks at the three years before the inversion, and the three years after. But before doing so, he waits for 3-month Treasurys to trade above the 10-year for a full quarter — a phenomenon that just took place in real-time — and calls that time zero in his analysis.
On average, the first year’s returns are -8.7%, followed by -7% after year two, and -8.1% following the third.
You read that correctly: three full years of negative returns. If you calculate the total loss, it comes to more than 20% — the threshold historically used to define a bear market.
What investors can do about it
But not all hope is lost — and Harvey has identified the perfect out-of-favor strategy for investors to exploit during this downtrodden period: the value factor.
For the uninitiated, investing in value stocks is a strategy aimed at finding shares trading low relative to their fundamental value. Investors can use a plethora of different measurements including, but not limited to price-to-earnings ratio, price-to-book ratio, and dividend yield to determine whether a stock is potentially undervalued and worth a purchase.
"Three years before a yield curve inversion, value does very poorly. Then, after the yield curve inversion, on average, value does well," he said. "So it’s really a nice historical hedge."
What’s interesting about his call is that a portfolio of value stocks has widely underperformed over the last decade, as investors have shed the exposure in light of momentum, and high-flying growth factors. So his strategy seems to be playing out as expected thus far.
Harvey leverages data to back it up.
Below he’s mapped out the cumulative average return of the value factor after the last seven yield curve inversions.
Research Affiliates After the first year, the value factor returns an average of 9.9%, 12.4% after the second, and 19.0% after the third.
In theory, this makes perfect sense. In times of heightened volatility, investors eschew high-flying issuance to adopt a more subdued, less-volatile strategy. Rotating into value early on may prove worthwhile.
For those looking to follow Harvey’s advice, these are two of the most popular value exchange-traded funds:
"Now is the time — as the risk of recession is dramatically increased — when asset managers earn their keep and when investors and advisors should re-examine the positioning of their portfolios, asking ‘do I have the right mix of assets and investments so that I’m as protected as I can be?’" he said.
Harvey concluded: "Factor investing is an obvious tool available to mitigate some of the downside risk."
See Also:
- A hedge fund manager who retired at 36 explains how a ‘doom loop’ in corporate credit is on the verge of upending the pension system
- Recession fears from Trump’s trade war have all but ensured the Fed will cut rates further. Here are the 12 stocks Goldman Sachs says could benefit most.
- The trading chief at a $3.3 trillion firm explains why investors shouldn’t trust their guts as market turmoil worsens — and why they should ‘trade small’ instead
Source: Business Insider – ccompetiello@businessinsider.com (Christopher Competiello)