Do you know what “yield curves” are? Today, Paul gets a question about them and explains what they are, what yield curve inversions are in the economy, and why they aren’t really an indication of specific market movements. Later in the episode, Paul says that the industry wants you to be stuck between market timing and indexing, but that there is another way forward called diversification.
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Paul Winkler: So I had a question. Somebody asked me a question. Before I forget I will answer it. And if you’ve got a question, there are a couple of ways that you can do things around here.
One of the main ways is, well, if you know my email address, you can use that. The easier way though is to go to the website paulwinkler.com/question, or if you go on the website, there’s an area on there where you can go and find it. It’s under the radio show or something like that. But you know, it’s paulwinkler.com/question.
So the question was regarding yield curves. Now, if you’re not familiar with what yield curves are, it’s not too terribly complicated.
Typically, what happens is this: If I borrow money for a long period of time, whoever is lending me that money is taking a risk that there could be a change in interest rates. And if those interest rates go up, they’re taking a risk that they’ve lent me money at a low interest rate, and then in the future, if interest rates are higher, they’re missing out because they’ve locked in a loan for a long period of time on a low interest rate.
So, long-term interest rates are typically a bit higher. If you look at 15-year mortgages versus 30-year mortgages, you’ll see that kind of thing. So typically you’ll find the 30-year mortgage has a higher interest rate. So some people will go, “Well, I’m just going to borrow for 15 years and that way I’ll keep the interest rate lower.”
But then you run into the risk, in that particular instance, that you have to make those higher payments, and you may not be able to make those higher payments, let’s say if you lose a job, if you’re disabled, or something like that.
But that is just really dependent upon the financial plan. But that is the idea of a yield curve. That’s the ideal.
The idea is that if I lend money for a very, very short period of time, the interest rate is typically lower than if I lend that money for a long period of time, and vice versa if I’m borrowing. So what happens is you’ll have people come out and say, “Well, yield curves and inversions, they are a bad thing.”
The idea is that if interest rates in the short term are higher than long-term rates, it’s a precursor to market downturns. I mean, that’s basically what people will say. “It’s a precursor to downturns. It means that the market’s going to turn down, we’re going into a recession.”
I’ll get to what people are wanting and then I’ll just talk about yield curves in general. You’ll have two-year treasuries. And if you look at a short year treasury, short-term treasuries, like one month, and the treasury bills, and you look at the interest rates, it’s been kind of a weird thing the past few years, as I’ve noticed.
It’s been more like a smile. In other words, you had higher short-term interest rates, then the intermediates went lower, and then the long-terms were a little bit higher, so it kind of looked like a smile.
Well, what happens with yield curves is typically you have this upslope, and the inverted yield curve shape is normally where those longer bonds are going to have higher interest rates. Now, it’s typically talked about if it’s the other way around as a harbinger of an economic recession.
So that’s why this stuff takes root, and this is why people talk about this stuff. If you have an inversion where the short-term interest rates are higher than the long-term, in the previous four times it’s happened, it has been followed by a recession. But the link is actually not so great and very helpful for trying to figure out market movements.
Now, for example, if you look at the trading days, I was just looking at some data on that, it took between 272 and 486 trading days from the inversion onset for the recession to arrive. So that takes about two years.
So in other words, you’re looking at a long time between when it inverts and when the recession actually occurs. Now to put it in perspective, the average U.S. economic expansion has been about five years. So that means that the average waiting time for a recession, regardless of the rate environment, has been about two and a half years, and in three out of four cases, the inversion was over before the recession even began.
So you look at that and go, “Oh, well wait a minute. Okay, the inversion, it’s gone back to normal.” And then the recession starts and you go, “Well, that was real helpful, right?” And also there’s not a lot of evidence that inversions are a cause for concern when it comes to investments.
People talk about the stock market and I’ll go, “Which stock market? Are you talking about large companies? Are you talking about small companies? Are you talking about value companies?
“Are you talking about international value companies? Are you talking about emerging market companies? Which ones? Which markets are you talking about?”
The market has, historically, posted substantial gains between inversion and recession in three out of the past four cases, which is what we expect, right? And you hear me say this all the time when I’m trying to predict market movements, and if I predict that the market is going to go down, I got a one in four shot approximately that I’ll be right. I got a three in four shot that I’m going to be right if I predict the market is going to go up.
That’s basically what you see here. And it’s been up double digits so far during the current inversion, so to speak, because like I said, it’s been a weird one.
There are a couple of pieces of data that you might find interesting. I was looking this up really quickly before the show.
Yield curve inversion, 1978, how long did it last? It lasted 988 days. Now, what happened is that you had, during that period of time to January of 1980, you had 346 trading days from inversion to recession and the cumulative market return was 13.11%. So much for that, right?
And we’re just talking about S&P right here. We look at 1988, and it went to 327 days. We had this period of time of inversion to July of 1990, trading days, 391.
What was the market return that you missed if you bailed out? It was 32.9%.
February 2, 2000, you had 230. Now everybody probably remembers that period of time because it was a tech bubble to March of 2001, 272 trading days. Now, that was market down 14.71%. But that doesn’t tell the whole story, because if you look at that same period of time, the year 2000, actually value stocks went up and small value stocks went up and small value the next year went up almost 30%.
Then you got December 27, 2005, 361 trading days for inversion to December 2007, 486 trading days, market cumulative return, 20.91%. And you look at it. We don’t know the most recent one. We haven’t finished yet.
We know where it’s going to end up. But that’s the reality of things.
It is the cycle that we go through as investors that I have to point out to people over and over again because you’ll hear something and somebody’s on TV. They’re telling you, “Hey, based on this, what’s going on, the stock market’s going to do this.”
I have to point out, there is a cycle you go through as an investor and it starts with a fear of the future. People are worried, especially in an election year.
“Oh, my goodness. What’s going to happen? Where is this whole thing going to go?”
We hear that one of the candidates is looking at price controls and you go, “Well, wait a minute. Last time that was tried, I remember Nixon, it didn’t work so well.” And then you have other people say, “Well, on the other side, he’s looking at tax decreases and that could be terrible.”
And people on both sides are worried about what the other side is going to do. Let’s just put it that way.
I try to stay apolitical on this whole thing, just because it doesn’t help. It’s like I was pointing out to somebody who was in my office and I said, “I was always looking through history. I go red, Republican, blue, Democrat, red, blue. And I’m going through history and I go, red, blue, red, blue, red, blue, mark it up.”
This market is just up, up, up, up. It didn’t really matter who it was, but people say, “It’s different this time.” And I have to point out, “Yeah, it’s always different.”
So you look at it and go, “Well, what will companies do to protect themselves from whoever is in office?” Well, they will have a game plan for whoever’s in office.
And let’s say that it’s really bad for the economy, let’s say it’s really bad, then they will do everything they’ve got to do to reduce expenses, to get earnings to go back up. But I digress back to the cycle.
“Will somebody please tell me?” And you know what? The investment industry is wonderful at coming out with some kind of a prediction as to what’s going to happen. And the media will dig up somebody that predicted last time when something happened, they predicted that it was going to happen.
They will find the person who predicted the future the last time successfully. So what they’re doing is they’re looking at past performance.
So I have this fear of the future. I’m looking for somebody, somehow, some way to tell me what’s going to happen in the future. So I look for things that worked in the past. And yield curve inversions used to work fairly well at times to help predict recessions, but it didn’t really tell us what the market was going to do.
But people equate recession with market movements. And you go, “Well, the market should go down during a recession, right?” Not necessarily.
You have the bad stuff before these things happen. It is like the 1973, 1974 downturn in the stock market was the precursor to the bad stuff that happened during the Carter years, during that period of time.
It was a tough period of time, but if you look at it, U.S. markets did fairly well during that period of time. As I recall, I think it was only one year down for the S&P 500. It wasn’t down much, but international markets just rocked during that period of time.
They did really well, and small caps did very, very well during that period of time. So we look for somebody that did it in the past, and then what we do is we get overloaded with information because everybody’s talking at us and we can’t hear a word you’re saying.
Everybody’s telling me, “Hey, we figured this out last time. We got this person. They’re really, really good. You need to listen to them because they really get this stuff.”
They will speak at such a high level that you will be convinced that they know exactly what’s going on, what they’re doing, and what’s going to happen next. They will be very, very convincing.
Then what happens is I get overloaded with information and I just go into shutdown mode. Just, “Calgon, take me away. I don’t know what to think.” This person’s saying it’s going to go up, this person’s saying it’s going to go down.
I was talking to one of my friends, an economics professor, this week. I was over at your Trevecca president’s dinner. And I get to talking to him, Dr. Hashi, and I go, “So, what do you think?”
And he goes, “Do you believe what so-and-so said?” He was talking about a really well-known economist. And he said, “He just lost his mind and he admitted it. He came back. To his credit he came back on TV and said, ‘I had just lost my mind.’”
And I said, “Yeah.” I said, “That is exactly it. Sometimes the smarter they are, the more they think they can figure out what’s going to happen next.”
I was talking about a Princeton professor. The guy was basically telling us we had to invest in Chinese stocks.
“You got to do this. You got to get involved in China. 2008. You got to do this.”
Oh, my goodness, if you had listened to that advice, how awful and terrible. Then you have guys like the economist Harry Dent, who just predicted 10 out of the last three recessions. He’s just constantly predicting.
Jeff: Over a hundred percent accuracy.
PW: Yeah, yeah, exactly, man. You couldn’t do that any better, man.
Jeff: Ten for three. That’s impressive.
PW: I’m just making up the number, but you know what I mean.
Jeff: It’s 300% accuracy.
PW: It’s a running joke. It’s a running joke that economists, if you look at their prediction of interest rate direction, seriously, it’s like 70% of the time they get the direction wrong.
Jeff: We have had like 20 supposed recessions in the last, what, four years now. It’s been like every time I look on Twitter or something, it goes, “We’re in a recession.”
PW: Yeah, man.
Jeff: “Okay, could someone actually confirm this now? Are we?” I don’t even know anymore. I honestly don’t.
PW: Oh, totally. Oh, totally. Yeah. And you hear people using the stock market, saying, “It’s a crash, and the crash is due to this person.”
Jeff: There was a little scare recently, though.
PW: Well, yeah.
Jeff: There was that little drop that freaked people out.
PW: But the problem that you run into is you go, “Well, what causes the drop?” People get scared and they don’t put money in or there’s very little buying activity. And then when people get scared, the amount that they’ll accept for the stocks that they own is much lower.
Jeff: Yeah, they’re selling at a sphere. Hopefully, it doesn’t go down anymore.
PW: And then it goes down and then all of a sudden they go, “Oh, oh, oh, the information was wrong.” Bam, it goes back up.
Jeff: It’s funny because I was actually doing a newscast during the week on the day it happened.
PW: Yeah, Monday.
Jeff: So I’m looking at the stocks and it’s going right back up. I think once I finished it was like three hours. It was at 400 instead of minus 1,300.
So I was like, “Okay, it’s going to come back up to even.” But still, at 1,300, it’s nothing to really laugh about.
PW: It is. It scares people. And if they’re afraid, they don’t know what’s coming, they don’t want to step out and pay a high price when they don’t know what’s coming.
So people will automatically drop the price that they’re willing to pay. And that’s when I tell people that you have the greatest wealth transfers.
PW: You look at the market throughout history. In a study from 1963 through 2004, what they wanted to know was how much of the market gain occurred in how many days.
Okay, so you have all these trading days in the course of a year, right? You have 365 days in a year, but you’re only trading a fraction of those number of days in the year, Monday through Friday, and then you’re off on holidays and things like that.
But you look at that and go, “Okay, how many days were responsible for 100% of the market gain?” The answer was that 96% of market gains were due to 0.9% of trading days.
And you go, “Whoa, which day?” Oh, my goodness. You’re looking like two to three days per year give us all the return of the stock market.
A lot of the information that we get from day to day, from minute to minute, is nothing but noise. It’s nothing but noise.
You have whisper numbers, is what they call them. You hear information and you go, “Well, based on this information, this might be happening for this company over here.”
It’s like you’re trying to solve this mystery and you need 30 clues to get it solved, but you only have two and you’re trying to figure it out. And little by little the information comes in and you go, “Ah, yeah, I know what we ought be paying for these stocks right now because the information is clear now.”
Well, that new information that really drives markets doesn’t come out that often. So hence what happens is, for the investor trying to figure out where it’s going to go, it’s futility at its highest level.
So we make emotion-based decisions. Since we have this dearth of information, we don’t really know what’s going to happen. What we do is we go, “I don’t know. How do I feel?”
That’s great. “I feel optimistic.” Oh, then you buy when you feel optimistic.
“How do I feel? I feel horrible and pessimistic and nasty.” And that’s what the media generally tends to do. They make us feel horrible, pessimistic, and nasty.
So I tell people, “Go outside. Only listen to this show. Go outside, walk through the grass, feel the wind on your face, watch the squirrels, watch the birds, because the likelihood of you getting something helpful from the media regarding what your investments are going to do is somewhere in the neighborhood between slim and none.”
So we make these decisions and then we end up with relative losses. And this is the thing that we find with investors from the DALBAR research over 35 years.
The average investor in the stock market has literally had a rate of return right around in an asset allocation portfolio, stocks, bonds, cash, about the same return as inflation. That’s pretty stinking bad.
And that is the reason: It’s that desire for a prediction about the future and then recognizing too late that the prediction was wrong, but you made a move based on it. That is the problem.
So yield curves, looking at yield curves, trying to figure it out … I’ve talked about butter production in Bangladesh being a great predictor. Just walk away when somebody is trying to tell you what the future holds for the stock market. You diversify the portfolio based on your time horizon.
The investment industry plays on it all the time because, quite frankly, if they can get you to listen to their predictions, they stand to gain. You tend to stand to lose.
PART 2
Paul Winkler: All right, I’m back here on “The Investor Coaching Show.” I am Paul Winkler. Paulwinkler.com is the website.
If you are a client of the firm, I am going to invite you to go to the website, paulwinkler.com, and if you hit paulwinkler.com/dinner, there’s an invitation to a dinner coming up. I’ll talk a little bit more about that coming up. Client appreciation dinner, it’s going to be really fun.
We got a really great speaker, an author, and just some of the people behind this project are pretty cool. Gary Sinise, Arnold Schwarzenegger, and Rob Lowe. So really, really pretty cool stuff. So check that out if you’re a client of the firm, paulwinkler.com/dinner.
If you’re not a client of the firm, just become one quickly. Please. Yeah, come on man, what are you waiting for? Oh, man.
Jeff: What a sales pitch.
PW: I know. You like that? It was like, see, I told you I am the worst salesperson in the world.
Jeff: Do it.
PW: A friend of mine said, “Just be a teacher.” And I was like, “Okay, I can do that.”
So speaking of teaching, there’s something I have been saying for quite a while. Okay, so when we talk about investing, we say don’t stock pick and don’t time the market. And people think, Oh, just buy index funds, right?
And then I say, “Well, index funds have a little issue in most asset classes: You’re overweighting bigger companies when you expect higher returns out of smaller companies.”
So index funds work pretty well with large companies, large international, and not so well with small companies or value companies, not so well with where you have most of your investments, quite frankly. You just don’t work as well. Returns are historically lower.
The reason is that you’re overweighting the bigger companies and you’re overweighting the lesser value companies when you expect greater returns out of value companies. But what happened is years ago it was talked about pretty heavily, that active management, and I talked about it here on this show for not quite 25 years. It’s getting there though.
But I’ve talked about that forever, that picking stocks and timing the market is just a big waste of time. So hence not going and using active managed funds where you have buying and selling going on is just a good idea. So what happened is that over the years — not because of me, but because I wasn’t the only one talking about it — you started seeing more purchases of index funds just because it was easy and it was cheap.
That became the new sales mantra of the investing industry, just, “Hey, this is less expensive and less expensive; hey, look at it outperform.” And the reason it outperformed was because, for a while, large companies outperformed small companies. Okay.
People mistook that as, “This is a better way to invest all around. Let’s just do this. Let’s just overweight this area, and let’s buy index funds.”
Well, all of a sudden, there started to be a little bit of a seat change where large companies weren’t outperforming. Well, it didn’t take long for the average investor to just bail out and move away from indexes.
That’s what’s in this article in MarketWatch, which is a Wall Street Journal publication, titled, “Why Investors Have Suddenly Halted the Long-Running Switch to Index Funds.” They just can’t stay disciplined to save their lives. Neither can the investment advisors.
They said Bank of America, and Merrill Lynch, had this big outflow and then an inflow into the active portfolios. And of course, as an investment company, when you deal with investment companies in general, and you’re not being disciplined, in my experience when I work for these big investment firms, if the client says, “Hey, I want to do this, I want to move over here now,” you go, “Okay, how high do you want me to jump because I don’t want to lose you as a client.”
Now my response is always, “You’re going to have to fire me. You’re going to have to fire me because I will not become part of the problem.” And it may seem a little bit hardcore.
“Well, it’s my money.” “Yeah, and you hired me to make sure you don’t screw it up. And I’m telling you, that’s why you have me on board, is to protect you from yourself.”
Because if you look at the DALBAR research I referred to in the last segment, I was talking about the investor, but the first time I ever saw that, it was the investment advisor and the investors that were both put together in the same study.
They were both messing up.
There was an article, and speaking of MarketWatch, I think it was MarketWatch that had this article back in early 2009. And they said that the investment advisors were shifting their client portfolios over from stocks to fixed-income investments. They said it was making money for the investment firm, but what about the clients? What a great question that they asked.
That was a great question to ask because it’s literally saying, “Hey look, the investment advisor is willing to move you wherever you want to go just to retain your business.” And what happened, of course, is through this in 2009, you had this huge run-up in the stock market and most people missed it because most of the return occurred in a very, very short period of time.
So they’re basically saying here that flows to active equity funds are strongly correlated with stock market dispersion. And so here it is.
Now you just heard me say that. What did I mean by that? Most of you’re sitting there going, I have no clue what you meant by that. And here’s what’s happening, is because this person is speaking at a higher level than what your understanding of stock markets is, they’ll sound like their geniuses.
Wow, this person’s talking about dispersion. I’ve never heard about that. Maybe I better listen to them.And with a big dispersion, that means that stocks are going to do this.
And then the investment advisors often fall for the same garbage as well. You’ve heard me talk about, if you listen to the show at all, the Indiana University USC studies where they looked at investment advisor portfolios. They found them screwing up their own portfolios just as badly as they were their clients even after they retired. That is it.
It’s trying to figure out what’s going to happen next. And often we don’t even realize it’s happening. You may not even know it’s happening in your portfolio.
You might have a target date fund. You have no clue what’s going on in the target date fund. I think it’s important not to blindly trust anybody.
Advisory services offered through Paul Winkler, Inc an SEC registered investment advisor. The opinions voiced and information provided in this material are for general informational purposes only and not intended to provide specific advice or recommendations for any individual. To determine what investments are appropriate for you, please consult with a financial advisor. PWI does not provide tax or legal advice. Please consult your tax or legal advisor regarding your particular situation.
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