The current bull market, which started around March 2009, has been the longest bull market since WWII. With the current bull run, the stock indices have increased by a significant amount. The Dow Jones Industrial Average went from around 8,200 points to over 24,000 points, an increase of 193% or around 21.4% annualized. The S&P/TSX Composite Index went from around 8,100 points to over 14,500, an increase of 79% or around 8.8% annualized.
As investors, we have been rewarded handsomely.
However, the longer the bull run lasts, the more people begin to get worried about a recession. Over the last few years, there have been many discussions on when the next recession might happen. So people analyze indicators like the historical P/E ratio, unemployment rates, building permits, housing prices, etc to determine the likelihood of a recession.
One of the more interesting indicators, I think, is the yield curve.
The yield curve looks at the difference between the yields on short-term and long-term US Treasury bonds. As you may know, yields on long-term bonds are usually higher than short-term bonds. Because investors typically demand more yield for a long-term investment to compensate for the greater risk they are taking on.
When we look at the past few recessions, something peculiar happened – the yield curve was inverted prior to the recessions.
What does that mean?
An inverted yield curve means that the short-term bonds (i.e. 2-year bonds) have higher yields than the long-term bonds (i.e. 10 years). This is an abnormal situation because essentially the inverted yield curve indicates that investors believe the economy will be better in the long-term than the short-term. So, investors are demanding more yield for a short-term investment because the near-term risk is much higher.
The yield curve inverted before the recessions of 2009, 2000, 1991, and 1981.
Recently, on Dec 3, 2018, yield curve inverted for the first time since the 2009 financial crisis recession. The yield on the US Treasury five-year note was 2.83, slightly lower than the three-year note’s 2.84 yield. The inversion was worsened on Dec 4.
Does this mean a recession is coming?
Should we freak out?
Yes and no.
In the past, the yield curve inverted 1 to 3 years prior to the recession, and typically when we talk about the yield curve inversion, it’s the spread between the 10-year bonds and the 2-year bonds. So when the yield curve inverted, the recession did not come immediately. The yield curve simply indicated that there was a very high chance a recession was brewing. In other words, although the yield curve inverted a few weeks ago, we probably won’t see a recession immediately. The inverted yield curve simply indicates that the likelihood of a recession in the next 1 to 3 years is much higher.
Another thing to keep in mind is that the smart people that work at places like the Federal Reserves and Bank of Canada are constantly looking at these recession indicators. They can then make changes to monetary policy to simulate or cool the market.
By now, you should know that bull and bear markets are cyclical. They come and go. And that over a long period of time, the stock market provides positive returns. If you are in the accumulating phase, a recession may be a good opportunity to add highly discounted assets to your investing portfolio.
Having said all that, although the inverted yield curve has been a good recession indicator, the market behaviour is not constant. Things are constantly changing. So the inverted yield curve may not be a good recession indicator for the next recession.
In the meantime, what should you do as investors? I believe you should all look at your asset allocation and determine whether you are comfortable with your current allocation and the associated risk level. If you are 99.9% invested in equities, are you going to be able to sleep well at night knowing that there’s a good chance your investments may lose 50% or more of their value? If you are investing 50% in equities and 50% in bonds, are you going to be able to sleep well at night knowing that your returns aren’t going to be as good when the market is firing all its cylinders? Remember, before you investing in anything, you should be asking yourself the 3 key questions. Look at your investment horizon. Are you tapping into your portfolio within the next 5 years? Or are you going to be investing for the next 30 years? Your investment horizon plays a significant role in how you should allocate your investment assets. Time is your best ally, learn to diversify through time.
For Mrs. T and I, we do not plan to change our investment strategy. We plan to continue saving money each month and use that money to invest in dividend-paying stocks and index ETFs. If the market goes up, great, our portfolio value goes up. If the market goes down, great, we get to buy stocks and ETF’s at a discount. Since we are only in our late 30’s, our investment horizon is quite long. Our goal is to become financially independent through passive income in our early 40’s (mostly through dividend income). Therefore, we don’t plan to tap into our principles. There’s no point freaking out about something (i.e. a recession) that we have absolutely no control over. We can only focus on things that we have control on – our income streams, our expenses, our savings rate, and how we invest.
If you keep worrying about something that you have absolutely no control over, then you won’t be able to sleep at night at all.
Why put you through that kind of hell?