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The threat of a recession is on the minds of many investors

August 21, 2019
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The threat of a recession is on the minds of many investors, predominantly due to irresponsible news articles that are inciting panic for investors who fear that they could lose money in stock or mutual fund investments. Shame on the press for the misinformation!

Some traditional measures of the yield curve are inverted and in the past, those have preceded recessions. (An inverted yield curve means that longer-term bonds are yielding a lower rate than shorter-term bonds) The link between an inverted yield curve and a recession has dominated recent financial news so heavily that for some investors mindsets, it's no longer a matter of whether we get a recession, but how long until it starts.

What these investors are ignoring is how different recent circumstances are from the environment that preceded prior recessions. Think back to the Panic of 2008.  The bubble in home prices in the prior decade pushed national home values more than $6 trillion above "fair value". The downturn was the worst we have seen since the 1940's. At the time, that over-valuation was the equivalent of about 50% of annual GDP.
 
The process of unwinding that massive over-valuation happened when bank capital ratios were significantly lower than they are today. And, more importantly, the unwinding happened when banks had to use overly strict mark-to-market accounting standards that required them to value mortgage-related securities at "fire sale" prices regardless of how solid the actual cash flow was on many of these instruments.
 
Pretty much everyone agrees that housing isn't grossly overvalued like it was in the years before the Panic. But some think we now have overvaluation in the stock market, so a downdraft in equities will play at least part of the role previously played by real estate, perhaps similar to the 2001 recession. Stocks were substantially overvalued at the peak of the first internet boom before the 2001 recession but are still undervalued today. The price-to-earnings ratio on the S&P 500 peaked at 29.3 on June 1999 (end-of-month, based on trailing 12-month operating earnings). At the end of July 2019, the same ratio was 19.3, more than one-third lower.

Meanwhile, the 10-year Treasury yield finished June 1999 at 5.81%. (If you remember a past commentary, I said that the 10 year Treasury yield would have to move up above 4.5% before that measure of valuation signaled overvaluation in the stock market.) Investors today would kill to get that kind of safe yield, versus the 1.55% on 10 year Treasuries we had at Friday's close.

In other words, the stock market is nowhere near the situation it was in about twenty years ago. Let's also think about the recessions of 1990-91 and 1981- 82, both also preceded by inverted yield curves, but also preceded by a heck of a lot else. Before the stock market crash of 1987, the Federal Reserve had been gradually raising rates. But the October crash temporarily threw the Fed off course, getting it to cut rates, instead. Once it was clear the crash wasn't the onset of another Great Depression, which some believed at the time, the Fed started raising rates again in early 1988. By early 1989, the Fed was targeting short-term rates near 10% and the yield curve was inverted out through the 30-year Bond. That's as if today were a secular bull market and the downturn recovered within one year, as you would expect in a secular bull market.

Unfortunately, the consumer price index (retail inflation) was up 5.4% in May 1989 from the year prior. Even "core" prices, which exclude food and energy, was up 4.6%. The Fed was tight but justifiably so, because tight money was the only way to reduce higher inflation. Remember, this was only a decade removed from bouts of double-digit inflation, and so, back then, it was tougher to wrestle higher inflation expectations out of the minds of investors, workers, and consumers.

By contrast, the largest 12-month change in the core CPI since the expansion started is 2.4% and the Fed hasn't adopted policy tightness to squeeze this out; if anything, with overall CPI inflation now at 1.8%, the Fed has hinted they'd like to see higher inflation. The same goes for the recession of 1981-82, but even more so. CPI inflation peaked at 14.8% in 1980 and was still hovering above 10% early in President Reagan's first year in office. So Fed Chairman Paul Volcker jacked up short-term rates to about 19% to smash inflation. By contrast, the 30-year Treasury Bond was yielding about 13%. Do you want to know what an inverted yield curve looks like? That's an inverted yield curve!

The bottom line is yes, the yield curve inverted before each of the recessions we discussed, but there were a lot of other things going on, not just the inversion. This time around we search in vain for a housing bubble, low capital ratios among US banks, mark-to-market rules that can turn a downturn into an inferno, a bursting stock market bubble, or a stubborn rise in inflation that the Fed has had to choke off with tight money. Without any of those ingredients, we still believe those predicting a recession in the near term are way too pessimistic.

The only bubble we see right now is in the bond market, (Not high yield bonds) with yields way too low given solid economic fundamentals. But, with the Fed unlikely to raise rates, that bubble's not bursting anytime soon. More likely it will be a gradual deflating as investors get better returns elsewhere and yields eventually move higher. Now is a rare opportunity to sell bonds. The values will not be this good for the foreseeable future. From this point on the bonds will fall in value as interest rates rise.

The economic news last week was not all negative; the US saw some surprising strength. Retail sales in the US for July, released last week, came in more than half of a percent higher than markets expected. The gains were not driven by auto sales, as is sometimes the case, because retail sales excluding auto sales were stronger than overall retail sales. The Consumer Price Index (CPI) also posted better than expected readings on inflation and the Philly Fed index posted a reading of 16.8, while the markets had been expecting only 10 during August. All these factors will need to be considered for the next FOMC meeting, at which there is currently a 100 percent chance of another rate cut. We may find out more during this week's Jackson Hole Economic Summit, which is always very closely watched by the investment community around the world for any signals as to what central banks around the world may do in the future.

Market Statistics
● Equities: Market movements last week were very similar to two weeks ago when looking at volatility and the eventual outcome of the week. Volume remained below average on all four of the major US indexes, despite earnings on a few key stocks driving investors to adjust positions. We have only a few more weeks of classic "summer trading," after which the markets should see volume pick-up and headline whipsaw action slowdown.

 
○ S&P 500 (-0.46%) - Average volume
○ NASDAQ (-0.56%) - Average volume
○ Dow (-0.75%) - Average volume
○ Russell 2000 (-1.34%) - Average volume

Source : Monday Morning Outlook 8-19-19: Callahan Capital Management Weekly Commentary 8-19-19


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