Hooray for the Yield Curve!

Break out the champagne! After being flat to down for more than a year, the yield curve has finally regained the upward shape that stock investors crave. Is this the magic sign we've all been waiting for? Are equities ready to begin another long march toward the heavens?

I wouldn't count on it just yet.

A what curve?
A yield curve is a simple graph depicting interest yields on short-term versus long-term fixed-income securities -- typically U.S. Treasury bills, notes, and bonds. The normal yield-curve state is upwardly sloping, an indication (for example) that a fixed-income investor demands a higher interest rate on a 30-year Treasury Bond than on a three-month T-Bill.

Economists have a grab bag of reasons for different yield-curve shapes, including the expectation of future interest rates, liquidity premiums for additional risk, and maturity preferences for various players in the bond markets. There's no clear consensus on which theory is correct; they all seem to make sense at different times and for different reasons.

Yield curves and the business cycle
But most market participants agree that an upwardly sloping yield curve means that interest rates are likely to move higher rather than lower in the future -- an indication of business-cycle expansion and economic growth. It doesn't always work out that way, but historic relationships between the yield curve and economic growth, although sometimes baffling, are also pretty compelling.

A timing problem
This all sounds good. But the timing of when the yield curve begins to point up and when the stock market starts to move in the same direction is far less clear.

Take the 2001 recession, for example, which officially started in March that year. Almost on cue, the yield curve began to regain its normal shape around February and March, and by the time the recession officially ended eight months later, the curve pointed sharply upward. But unfortunately for the broad stock market, November 2001 was a false peak. Equity investors suffered through another 15 months of pain -- and nearly 30% more on the downside -- before the S&P 500 finally hit its trough in February 2003.  

We may have a long way to go here before it's time to break out the champagne. If you want to look at the relationship between the yield curve and the S&P 500 over the past eight years, take a look at this interactive chart.

Will history repeat itself?
That's the million-dollar question no one can answer. All I can tell you is that the signs look ominous. It's common for the real estate market to weaken before a recession and for weakness to plague the markets. But last week's bailout of Bear Stearns and the unprecedented three-quarter-point drop in the discount rate by the Federal Reserve look more like steps to avert a meltdown than a carefully orchestrated effort to manage the economy.

Wall Street cheered both actions, but are we considering how slippery the slope must be to cause the Fed to act that precipitously? As history suggests, just because the yield curve has steepened upward, that may not be reason to celebrate just yet. Our economy has some serious problems to work through, and I'd expect the market's true recovery to lag the upturn in the yield curve, as it has in the past.

Recession survival
So what's a bear to do? Our Recession Survival Guide will help you tread these rough waters, but here are a few starting points.

  1. Don't try to time the market. Unless you're a heck of a lot smarter than the average bear, it simply doesn't work. A wealth of studies have shown that over the long term, stocks yield the highest returns. But it's not a steady ride, and being out of the market during the rare days when stocks bottom and then make a big upward move cuts your return significantly.
  2. Invest in great companies -- with long operating histories, strong balance sheets, and solid cash flows. You already know which companies these are. They're usually the leaders in their industries and will prosper from the woes of their more poorly capitalized competitors. Downturns provide opportunities to buy these good companies on the cheap. General Electric (NYSE: GE  ) , Microsoft (Nasdaq: MSFT  ) , and Coca-Cola (NYSE: KO  ) come quickly to mind, but you can make the same case for Johnson & Johnson (NYSE: JNJ  ) , Apple (Nasdaq: AAPL  ) , Wal-Mart (NYSE: WMT  ) , and a host of others.
  3. Avoid toxic waste. Market sectors such as homebuilding and financials have had a rough ride, and I expect that trend to continue for a while. Don't get enamored with stocks that are well off their 52-week highs unless there's good reason to believe they will perform during a sour economy. They may look dirt cheap, but they're simply not worth the risk when other sectors, such as consumer products and health care, are showing that they can weather the storm nicely.

And finally ... be patient. Trust that the yield curve is predicting better times ahead. It may be awhile yet, but those better times are coming. Put yourself in a position to ride out the storm, so you can take advantage of conditions when they begin to improve.  

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