John Lynch Chief Investment Strategist, LPL Financial
There are several market myths related to certain market indicators which have the tendency to distract investors from what really matters in assessing market opportunities. We believe the overall fundamental backdrop is currently quite positive thanks to solid economic growth and strong corporate earnings trends, while market sentiment and technicals continue to suggest future equity strength. This week we will bust some common market myths.
MYTH 1: THE YIELD CURVE
The yield curve has flattened throughout 2018, causing some to fear that a recession may be right around the corner. This makes sense, as the past nine recessions all saw a yield curve inversion right ahead of the economic contraction. The difference between 2- and 10-year Treasury yields broke below 0.50% recently, reaching 0.41% just last week—the flattest it has been since September 2007. Though significant, it is important to note that when looking back at the previous five recessions, once the yield curve hit 0.50%, it took a median of nearly a year before the curve inverted. Once it inverted, it took about 20 months until a recession started. All along the way, the S&P 500 Index posted a median return of 21.5% over those 32 months. In other words, there could be years left to this expansion before the yield curve truly becomes a worry. For more of our thoughts on why we believe the yield curve isn’t yet a major concern, be sure to read our latest Bond Market Perspectives, due out tomorrow.
MYTH 2: A MANUFACTURING PEAK
The Institute for Supply Management’s (ISM) Manufacturing Index hit a cycle high back in September 2017, but then made yet another new cycle high in February 2018. Many have posited that a peak in manufacturing suggests an impending recession, but the data does not back this up. Over the past five economic cycles, it has taken the United States 45 months on average to enter a recession following a peak in the ISM. Meanwhile, the average cumulative S&P 500 price return during those periods (using end of month returns) was 56.7% [Figure 2]. Note that this average includes periods of very strong returns in the mid- to late-1980s and 1990s, and one period of negative returns in the early 1980s, which is an indication that not every cycle is equal. With ISM manufacturing making a new high so recently, we think this means there is still plenty of time left in this economic cycle.
MYTH 3: RISING INTEREST RATES
With yields surging around the globe, breaking out to multi-year highs in several cases, many think that higher rates are a bad thing. The data suggest quite the opposite. We have found that stocks and bond yields historically have been positively correlated until the 10-year yield gets up around 5%, at which point the correlations break down. In other words, it is perfectly normal for yields to rise along with stocks. Taking this a step further, Figure 3 shows that out of the most recent 23 periods of higher rates (based on the 10-year Treasury yield), stocks have gained ground 19 of those times. Recent periods have produced even better performance, as stocks have risen during each of the last 11 periods of rising rates (since 1996). Stocks have done well since interest rates began to move higher in September 2017. History suggests that higher rates may actually be a good thing, and should the 10-year Treasury yield break above the psychologically important 3% level, the equity bull market may garner further support.