December 9, 2018 Inversion

Risk/Reward Vol. 401

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

An inverted yield curve, a reduced likelihood of a China deal, the re-emergence of Mr. Mueller and a disappointing jobs report combined to send all three major indices into the red for the week. The S&P 500 and the Dow Jones Industrial Average are at net losses for the year, and the NASDAQ is barely positive. Indeed the tech heavy NASDAQ which had been so bullish for much of the year has lost nearly 8% in the past month and nearly 12% in the last three. For the reasons stated below, I don't see any relief in sight---not even a traditional Santa Claus rally.

The most significant downward impetus this week was the inversion of the yield curve. Allow me to explain. The different yields demanded by bond investors along a duration span say a lot about how they view the US economy. If there is a big positive difference between short and long term bond rates---for example a steep yield curve as durations lengthen from 2 to a 10 Year bond---investors expect robust future economic growth and concomitant inflation. But if that difference declines---that is, if the curve flattens---it indicates that investors believe growth and inflation will be slow. If the yield curve inverts---that is, short term rates are higher than longer term rates---it indicates that investors believe the economy will actually contract and the Fed will have to cut rates. This week the yield on the 5 year US Treasury Bond fell below that of the 2Year; to wit, it inverted. This signaled to the equity markets that future growth and thus future profits may disappoint. Future profits are the "mother's milk" of stock prices. No wonder the market dropped. In addition, the downward momentum caused option traders to reduce the likelihood of a rate increase in December from 83% to 72% and the likelihood of two increases in 2019 from 58% a month ago to 28% as of the close on Friday. This is not good news for fixed income investors such as yours truly.

With Mr. Mueller heating up again and The Donald going ape on Twitter, I see a lot of upheaval on the horizon. Add to this a subpoena happy Democrat controlled House of Representatives and all one can do is switch to Netflix and hunker down for some very troubled times. Mr. Market abhors troubled times. I have said it before but it bears repeating. Winter is coming.