Recently, all talk has been about the inverted yield curve meaning that short-term interest are higher than long-term interest rates. It is seen as a signal that a recession is on the doorstep and knocking at our doors. The yield curve has inverted before every recession since 1955!
Does this mean we see a serious bear market? I do not think so!
First of all, past recessions have started an average of 15 months after the inversion. This is more than 1 year to go! A lot of things can happen during this time.
Second, the economy is in a pretty healthy state: unemployment at record-low, rising wages and record-high household income.
Third, U.S. bond yields have dropped because foreign bond yields in Europe and Japan are a lot lower and facing negative interest. Indeed, the yield on more than $15 trillion global bonds is negative. As a result holders of such bonds will get back less than their original investments! This motivates international investors to seek higher yields in U.S. bond market, driving US yields even lower.
Here is one of the best and most accurate stock market buy-signals:
Stock Market dividend yields vs. U.S. Treasury bond yields
Why exactly is this one of the best and most accurate signals in stock market history?
In the first half of the 20th century, this indicator worked like a swiss clock: Investors who bought stocks when the stock market’s dividend yield exceeded the yield of a 10-year Treasury bond were in for every single major stock market rally. The returns were huge and the system made total sense. The logic behind it:
Stocks are riskier than bonds, so stock yields should compensate more for greater volatility and the possibility of occasional losses.
The system worked until 1958. Then it stopped. Why? Because for the next 50 years, stocks never yielded more than Treasury bonds. Publicly traded companies began using their cash flows to fund operations and acquisitions rather than paying out dividends to shareholders. With stock yields sharply lower, the indicator was completely dead.
It took a full-blown financial crisis with stock prices tumbling and bond yields going towards zero for it to happen again. Just weeks before the stock market made a dramatic bottom in early 2009, this accurate and unique indicator came back to life. It took 51 years exactly but it worked perfectly again. It flashed again in the summer of 2011. Again, a perfect signal to buy the stock market. Now, for only the 3rd time in 61 years this accurate signal is flashing again!
Why is it happening again? The rising government bond prices combined with the simultaneous correction on the stock market sees 10 years treasury bond yields diving and the stock market dividend yields rising. Stocks are yielding more than bonds now: The S&P 500 currently yields just below 2%, while 10-year U.S. Treasury Bond yield around 1.50%.
An investor, who buys an S&P 500 index fund will earn more on dividends over the next decade than an investor receives interest payments on a 10-year Treasury bond. Even if equities go nowhere and dividends (that historically rise 5.8% per year) don’t increase at all. Both scenarios are very unlikely, looking at history.
This indicates that stocks remain a terrific long-term buy, while Treasuries are no real alternative, yielding less than the current inflation rate.
Have on mind: There are no guarantees in the world of stock market investing. It doesn’t mean that stocks can’t sell off more in the short term or that bond prices won’t rally further. But one of the best indicators gives you the green light in the long run!
Sven Franssen