Looking Around the Curve and Over the Hill

Inverting the Digest... The yield curve goes wild again... More trouble ahead, but how much?... Looking around the curve and over the hill... The 'midterm year catalyst'... Speaking words of wisdom...

In the spirit of Charlie Munger's concept of 'inverting'...

Today, we're doing things backward and starting at what normally comes at the end of the Digest – your feedback.

The primary reason is that we received two comments overnight worthy of some extended replies...

It also helps that my colleague Dan Ferris wrote so eloquently about the power of "inverting" your ideas about the past few decades just a few weeks ago. We can't stop thinking about it – so why not take our own advice?

This is especially interesting when we see a question about inverting itself, though not referring to Munger's definition. Instead, we're looking at what's going on in the bond market. As subscriber Trish J. wrote in this morning...

Has anyone noticed that the 10- and 2-year Treasury has inverted for the third time this year?

Does anyone have any thoughts about what that means?

Hint: Greater depression or total collapse?

I (Corey McLaughlin) will get right to it...

First, I'm glad to have seen this message. It means our previous warnings about a funky yield curve – the first back in January and again in April after it inverted – didn't fall on deaf ears...

Second, yes, we've noticed... The yield curve – the various interest rates paid out by different durations of "safe" government-backed U.S. Treasurys – inverted again recently.

I planned on discussing it soon. But since you asked, Trish, there's no time like the present...

I don't think any of our editors or analysts would say that just one indicator signals that a "greater depression" or "total collapse" is guaranteed in the future. But the yield curve behavior you noted lately definitely isn't bullish...

As our colleague Brett Eversole wrote in the May edition of our Portfolio Solutions products, the yield curve is one of many indicators that has suggested we're headed for a recession (or are in one already).

The trouble with the curve...

We've noted before that when yields on U.S. Treasurys invert – that is, when shorter-term U.S. Treasurys fall in price enough that they yield more than longer-term bills or bonds – it has been a reliable signal that trouble is ahead for the economy...

This might sound complicated or dull, and it might be something you want to ignore, but it's a really simple and powerful concept. As our colleagues at DailyWealth Trader recently explained...

When you buy a Treasury, you're loaning money to the U.S. government. And normally, the government needs to pay you a higher interest rate to tie up your money for longer amounts of time.

If, for example, the U.S. pays 1% per year on a two-year loan (a two-year Treasury), it might have to pay 3% per year on a 10-year loan (a 10-year Treasury).

This is the natural order of things because the risk of any loan increases with time... You might think you have a reasonably good idea of what's going to happen over the next year or two. But you don't have nearly as good of an idea of what the world will look like in 10 or 30 years...

Investors should demand a higher interest rate to compensate for higher risk.

Once in a while, though, yields invert – short-term Treasurys like the two-year yield more than long-term Treasurys like the 10-year. It shouldn't happen, but it does. And it's a clear sign that something is amiss in the markets.

And when you consider government-backed U.S. Treasurys are a $22 trillion market – more than 20 times larger than the total global market cap of cryptocurrencies today, for example – their behavior is significant to track...

Below is the spread between the 10-year and two-year Treasurys since the mid-1970s... The gray shaded areas indicate recessions.

There is a correlation... You might notice that whenever the yield curve has inverted multiple times or for an extended period of time, a recession has always followed shortly after.

Said another way, if enough Treasury holders (the Federal Reserve being one of them) are saying they're more worried about the short term than the long term, it can become a self-fulfilling prophecy.

As Trish noted in her question, the 10-2 spread went negative for the third time earlier this week. With bond prices falling slightly today, the 10-year rate rose to 3.015% and the two-year rate was around 3.047%. Remember, bond prices trade inversely to yields.

You calculate the spread by subtracting the two-year rate from the 10-year because the longer duration should have a higher yield. That means the math will be positive except in extreme times. And those are the times we want to pay attention to.

The first inversion occurred in late March and the second, briefly, in June. A third is more confirmation that trouble is ahead...

But what kind of 'trouble'… and when?

As Brett noted in May's Portfolio Solutions issue, historically, recessions start between six and 24 months after this signal occurs. That means we could see one between the last half of this year and 2024.

This wouldn't surprise us at all.

In fact, as I wrote on Tuesday, a recession is all but "official" already. After all, second-quarter U.S. gross domestic product ("GDP") is projected to decline after it did the same in the first quarter... and consumer sentiment is at an all-time low because of inflation.

As for what this means for the stock market, when the yield curve has inverted before the previous three recessions, stocks have enjoyed a small bull run before peaking, averaging a 21% gain over the following 18 months or so.

That hasn't happened this time... At least not yet.

Things could turn around for stocks toward the end of the year at the same time a recession is causing the most pain to the most people... if the Fed lowers interest rates and eases monetary policy again, or signals that it will.

This would make a lot of sense...

We often have a disconnect between Mr. Market, the economists and decision-makers at the Fed, and Main Street. The stock market is forward-looking. Economic data is backward-looking. That goes for recession calls, too.

As I wrote in the April 1 Digest...

By the time there's enough data to officially "call" a recession – many people consider it two straight quarters of GDP decline – slower growth has already hurt companies and everyday Americans for at least six months, or two quarters.

Only then does everyone realize or say in public... "We're in a recession." Much like inflation has hit the wallets of millions of people for at least a year, the effects of a recession are felt long before anyone in Washington, D.C. or anywhere else starts making speeches about them...

Meanwhile, Mr. Market is forward-looking, with prices fluctuating based on current values and future expectations. Or at least the "smart money" in the market is forward-looking...

That goes for folks buying or selling stocks and bonds and any other asset over the long term. On balance, over the past few months, Mr. Market has been pricing in lower "growth" ahead... That's why stocks are down this year.

This trend hasn't changed.

As our friend and colleague Greg Diamond updated his Ten Stock Trader subscribers today, even with a rally in the U.S. indexes this week, he's still seeing a lot of "divergences" beneath the surface. That means some stocks or sectors are falling while others gain...

That's not bullish. Plus, all of the major indexes are still well below their long-term trend (200-day moving averages). And the tech-heavy Nasdaq – the biggest gainer this week – is still below its short-term trend (50-day moving average).

So the same advice we've been sharing the past few months still applies. There's nothing wrong with having too much cash on hand right now. It could also be smart to own high-quality, low-volatility stocks in your portfolio or make a few bearish bets on lower stock prices ahead.

Moving on to a different piece of feedback about politics...

Paid-up subscriber David M. wrote in with some kind words in response to yesterday's Digest – and a projection...

Corey, I appreciate you explaining the 'how' of things in the market. This gives me a better understanding of the market and less fear of what is to come next.

With that I am amazed how all analysts seem to dance around the political arena not being willing to put this all into perspective. I know the why of course – half of us have a mis-conception of their politics. The other half can see through the fog and recognize what is really happening with policy that affects the markets.

Cutting to the chase here, I believe that one of two scenarios will play out in the coming years – my projection. Either the electric car industry reduces demand of oil across the world to bring prices of oil down or a Republican party takes the White House in 2024 to support the oil industry giving everyone the choice of electric or oil.

It seems to me a lot of average folks are going to suffer economic hardship in the next two years. I don't disagree with the ideas of the far left but this is the land of the free. Having choices is what our country is all about. We make the right choice when given the opportunity.

Thank you Corey for giving us the opportunity to understand and make those right choices.

First off, I want to thank David for the note.

In my career, I've always been a believer in giving people the information they need and allowing them to make decisions or inferences... or completely ignore what we're saying. That's a choice.

But regarding the specific feedback and your projection, you bring up a good point in that the political cycle is about to come to the forefront again in the markets...

Introducing... the midterm year catalyst...

I'm about to sound like I'm hawking something, but this is part of our friend Marc Chaikin's new market update that we've mentioned recently.

If you haven't checked that out yet, it's worth a listen. I can tell you he shares compelling findings about how the markets have behaved in midterm election years like this year... I know you talked about the next presidential election in 2024, but we're not quite there yet.

It turns out that over the past 100 years, midterm elections have frequently occurred in bear markets or when the market has been just coming out of one... and the history is bullish in the long run. As Marc explains in this new video...

If history is any guide, there is an 85% chance that stocks are going to soar from a market bottom this year – with the whole market going up between 40% and 50%.

I haven't seen anybody in the mainstream talking about this right now, and it's enlightening information. You can watch Marc's entire presentation for free right here.

Beyond that, whenever somebody brings up how politics connects with the markets, I immediately think of two things that I've learned since joining Stansberry Research...

The first is something you'll hear several of our editors say...

Politics and election results are just parts of the market...

Ahead of the November 2020 presidential election, our colleague Dr. David "Doc" Eifrig covered this idea in depth in his signature Retirement Trader newsletter. As we shared in a September 2020 Digest...

The machinations of the Federal Reserve, the economy, and the thousands of businesses and millions of individuals wash out most of the effects a president can have on the stock market.

He urged his subscribers to think about other tangible financial factors rather than focus on a single election or what's happening on Capitol Hill. Sometimes, something like a big tax cut can boost stocks, Doc said, but that's a rarity.

Now, to the question at hand... I'm not saying that the future of energy in this country, as David mentions, is insignificant, nor that folks shouldn't be able to choose the type of car they drive or how they power their homes. We should.

We have a growing global population, no shortage of geopolitical conflicts at least somewhat tied to natural resources, and often incompetent, misguided, or out-of-touch politicians. So what happens next in the energy industry and others is a worthwhile topic of discussion.

Either through organic means or political coercion, there will continue to be innovations and new companies worth investing in over the next decade as changes happen. Politics likely will have something to do with it...

If the government throws millions or billions of dollars of support at a particular industry, that matters. We have seen this with microchips, where legislation has been in the works for over a year but hasn't crossed the finish line yet...

And I'm not naïve to the fact that politics is awash in greed, conflicts of interests, power grabs, and downright criminal behavior... and that the depressing state of politics today and short-sighted decisions can lead to chaos among everyday people.

But often, too much is made about how or if politics influences real, tangible returns in the markets for most people. Take today's news about British Prime Minister Boris Johnson resigning...

In practical terms, the political leader of one of the world's most powerful nations quitting in disgrace after dozens of his former supporters resigned is not a good look... nor a preferred reality for the people of the United Kingdom staring down inflation and an energy crisis.

But if anything, the markets took the "BoJo" news and shrugged it off, at least for today. The U.K.'s FTSE 100 Index was up 1.1%... and the pound sterling gained a little bit, though it's still at multidecade lows.

As for the second idea you'll hear from our editors...

With policy, often the opposite of what you might expect happens anyway...

The late, great P.J. O'Rourke – a former Digest contributor – captured the idea that Republicans and Democrats have often driven the U.S. economy where most people least expect them to...

I shared these words from P.J., originally published in American Consequences magazine, the day after Election Day 2020. They're worth sharing again while we're on the topic of politics and markets. He wrote...

The political parties claim to be able to navigate us around or through war hazards and economic crises... But the pilots they bring on board are often hopeless landlubbers looking through the wrong end of the telescope with their nautical charts upside down. (I'd say we've got two of them on offer this November 3.)

In fact, Republicans and Democrats often take us to exactly where you'd expect they wouldn't...

For the past 150 years, the most broadly punishing financial panics, recessions, and depressions have begun while for-the-love-of-money Republican presidents were in power, rather than share-the-wealth Democrats:

• The Long Depression of 1873 to 1879 – Ulysses S. Grant
• Panic of 1882 – Chester Alan Arthur
• Panic of 1893 – Benjamin Harrison
• Panic of 1907 – Theodore Roosevelt (OK, trust-busting TR was tough on big business so maybe we can blame this on his inner Democrat.)
• The Great Depression – Herbert Hoover
• Stagflation of 1973 to 1975 – Richard Nixon
• Dot-com Bubble Burst – George W. Bush
• The Great Recession – W. again

To add perplexity to paradox, during most of the 20th century it was the internationalist, peace-loving, why-can't-we-all-just-get-along Democrats – not the bellicose, saber-rattling Republicans – who sent the nation into combat:

• WWI – Woodrow Wilson, who'd been elected on the promise he'd keep us out.
• WWII – FDR, who got elected by promising something similar, though less of it.
• Korea – Truman (who, in fairness, made no such promises).
• Vietnam – JFK and LBJ.

The pattern became proverbial. "Elect a Republican, get a depression. Elect a Democrat, get a war."

Of course, since then, the pattern has gotten mixed up, with Republicans taking the lead in sending troops to godforsaken places and Democrats doing their best to impoverish us all with high taxes, social spending, regulatory interference, and vows to implement lots more of all three.

If there ever was a pattern... You think you know what party is what, then that party goes all whatchamajigger.

First it was the Democrats who favored low tariffs and free trade, then it was the Republicans. First it was the Republicans who supported racial equality, then the Democrats took over. Democrats used to be able to count on blue-collar workers, then there was nothing left to count. Southerners once were "yellow dog Democrats" who'd "vote for a yellow dog" rather than vote Republican – then southerners elected the mutt. John F. Kennedy lowered taxes. George H. W. raised them.

This is all to say, we're careful with how much time we spend in the political prognosticating game... Hopefully you can see why.

But no matter what we think is the best way of looking at things, politics and elections in midterm years during down markets, as Marc says, can be catalysts for big market moves because of what everyone else thinks.

A final thought...

To this point, let's end with some words of market wisdom from someone much smarter than me...

In a recent interview with our editor-at-large Daniela Cambone, noted investor Rick Rule shared this observation from spending decades in the markets...

In terms of making investment decisions, sometimes things that aren't true but are widely believed are in the near term more important than things that are true but are, in fact, intellectually anomalies.

This idea can be helpful to keep in mind all the time, but during market extremes in particular...

In other words, sometimes the truth doesn't matter to Mr. Market in the short term. But it will eventually. As Warren Buffett once said, in the short run, the market is a voting machine (a popularity contest). But in the long run, it's a weighing machine (of substance).

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New 52-week highs (as of 7/6/22): General Mills (GIS).

In today's mailbag, more thoughts about a recession... feedback on yesterday's Digest... and yet more kudos for Dan Ferris' latest Friday Digest... Do you have a comment or question? As always, send your notes to feedback@stansberryresearch.com.

"[A recession] will not happen now. Americans [are] too spoiled and will not stop spending, the motivational force of the economy." – Paid-up subscriber Michael S.

"You quote: 'You could define a bear market as the rising value of the U.S. dollar versus financial assets.'

"You could, but you would be mistaken. The fact that the dollar has risen against other major currencies, has nothing to do with the U.S. bear market, and everything to do with foreign bear markets. The dollar has fallen in domestic purchasing power because of inflation.

"In a bear market heralding an inflationary recession get out of all financial assets including money. As long as inflation continues your money's domestic purchasing power will continue to fall. It is hardly consoling to know that you can now buy more euros." – Paid-up subscriber Kendrick M.

"Hi Dan, Thank you for a very thought-provoking essay, the best of anything I've read this month.

"A world driven by ideology in place of economics has become the growing trend led by a young generation of millennials who appear to care less about traditional values, having learned little from history thanks to an inferior public education." – Paid-up subscriber Wayne S.

All the best,

Corey McLaughlin
Baltimore, Maryland
July 7, 2022