This week (01Apr2022), the yield curve has inverted in U.S Treasury bond markets. This is big news in financial media. Why is this a significant event? According to experts, the inverted yield curve is one of the best predictors of impending economic recession. However, is it a good predictor of an equity bear market?
As an investor, the question that interests me "Is the inverted yield curve a good predictor for an impending equity bear market in a timely fashion?" The keyword here is timely. Being early in financial markets is as good as being wrong even if the prediction turns out to be right eventually. It is useless in making predictions about bear markets, selling out early, only to see the market rise another 30% before the bear market finally sets in.
Based on the number of news articles about the inverted yield curve, it seems market participants are getting spooked. It is a good habit to do an independent study on my own to avoid getting spooked and sell prematurely. Besides, I enjoy studying the financial markets anyway.
I downloaded 69 years of monthly Treasury bond yield data all the way back to April 1953 from FRED (Federal Reserve Economic Data). This data source is as credible as it can get. I downloaded the corresponding 69 years of monthly S&P500 price quotes from Yahoo Finance. The prices have been adjusted for splits and dividends. You can download all the data and verify my results.
The table above shows S&P500's 3-month to 12-month gain after the first occurrence of an inverted yield. There were only 12 such occurrences in the past 69 years. Notice that the sample size is not large enough in the first place to draw reliable conclusions. This is a flaw when conducting data analysis on rare events.
From 1955 to 1970, investors who sold after an inverted yield curve occurred will look smart most of the time.
Unfortunately, from 1980 to 2020, investors who sold after an inverted yield curve occurred will look stupid most of the time. Investors who used the inverted yield curve as a selling indicator did not do well over the past 40 years.
I tried to verify from the data whether the inverted yield curve is a timely predictor of the end of a bull market and the start of a bear market (best time to sell). I use the 13-month peak to mark this best time to sell.
Months classified as inverted yield months
- 1yr yield < 10yr yield or 2 yr yield < 10yr yield or 3 yr yield < 10yr yield
Months classified as the first occurrence of an inverted yield
- Inverted yield happened in the current month but it did not happen in the prior 6 months
Months classified as 13-month peak
- Current month stock index price is higher than all prior 6 months and higher than all future 6 months. This is the start of a major bear market and the best time to sell.
A good question to ask "How often does an S&P500 13-month peak happen at around the same time as an inverted yield curve?
In other words, "How often was the S&P500 preceded and/or followed closely in time by the first occurrence of an inverted yield curve?"
Here is the answer I got from the data.
There were 28 13-month peaks in S&P500 from Apr 1953 to Feb2022. Out of these 28 occurrences, 7 of them were accurately predicted by the inverted yield curve in a timely fashion. All 7 happened between 1955 and 1980. None of the 7 accurate predictions happened in the past 40 years.
I will not dispute the claim made by experts that an inverted yield curve has been a good predictor of an impending economic recession. I do not have the formal qualifications to argue with the experts. However, as a bear market (not the same as a recession) predictor, this independent study convinces me that the inverted yield curve has not been a good predictor in the past 4o years.
The inverted yield curve has not been useful for predicting equity bear markets in a timely fashion in the past 40 years. As an investor/trader, I am not going to get too worried about inverted yield curves today. It is more noise than signal.