Can Widely Followed Indicators Make You Money?

The spread between the 5 year treasury yield and the 2 year treasury yield inverted which sent financial markets into a frenzy as the S&P 500 fell 3.24% on Tuesday. The more popular 10 year/2 year spread is only 12 basis points away from inverting. Usually, when the curve inverts the difference between each part of the curve is small. This cycle could be different if the 10/2 year spread doesn’t invert soon. The more hawkish the Fed is, the more likely it inverts as well.

The yield curve is an interesting metric because it has a solid track record in America, and it is widely followed. There’s no way of measuring the prevalence of indexes, but every financial website covered it and the discussion dominated FinTwit. It’s possible that because we’re in the information age most successful indicators will be well known. This situation is interesting because some feel when a metric gains prominence, it loses all ability to make you profits.

Logically, it’s possible the yield curve inversion will cause volatility sooner than previous cycles because almost every investor is following it and views it bearishly. If an investor suffers from recency bias, he/she may believe the next recession will cause a 50% decline in stocks. If you think a 50% decline will occur in the next 1-2 years, you don’t care about profiting from the last few months of the bull market.

13.1 Months Until The Stock Market Peaks

The yield curve isn’t a silver bullet, but it gains veracity by the current economic slowdown. It’s one more support argument for a slowdown/recession rather than the only one to base your entire outlook on. The average lag time in the past 5 cycles from when the 10/2 year curve inverts until the next recession is 22 months. As of November, the Cleveland Fed’s recession indicator states there is a 20.3% chance of a recession in the next year.

The lag time until the stock market peaks is 13.1 months. Average returns are 21.8% after inversions. It’s important to avoid assuming this cycle will be average. In 1978, it took 0.8 months from the inversion to the S&P 500 peak and in 1998, it took 22.3 months. Like we mentioned earlier, many investors are willing to leave the 21.8% gain on the table to avoid a 50% loss. The problem with that logic is a 50% decline is far from a guarantee.

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