The yield curve has inverted: Here’s why investors shouldn’t freak out and go to cash

The yield curve has inverted: Here’s why investors shouldn’t freak out and go to cash


So last week investors, for a lack of a better term, ‘freaked out’ over the yield curve inversion, when 10-year interest rates moved lower than 2-year rates. The yield curve has inverted before, but this was the first time since 2007. Since we all know what happened after 2007 (hint, it wasn’t good), portfolio managers and investors collectively decided we are now firmly headed for a recession and the equity world was ‘over.’ It was time to sell stocks after a nice 10-year run. But is this a wise move? Probably not, for these five reasons:

There is still lots of money to be made (maybe)

As noted, the yield curve has inverted before, and yes, it does usually lead to recession, eventually. However, theaveragestock market gain in the 18 months following an inversion has been 15 per cent. It seems that the main result of all the worrying about the yield curve is lower stock valuations, which tend to lead to better-than-average short-term returns. In 1988, the yield curve inversion led to a 29 per cent gain in the stock market prior to the start of a recession. Do you really want to leave these potential market returns behind?

Most recessions are fairly short

In the past 75 years, the average recession has lasted 10 months. Even the ‘bad one’ in 2008 lasted only 18 months. Considering current economic strength, it is hard to see how any upcoming recession, if at all, would be any worse than average. Thus, do you really want to completely change your investment portfolio for something that might be very short, even if it happens at all? Generally, short term ‘reactions’ to market and economic events simply end up costing investors money, or at least missed opportunities.

Bank of Canada

You might lose 21 per cent, or even 37 per cent

Suppose you are scared of a recession and want to ‘go to cash’ with all your investments. Maybe you are in a taxable account with embedded market gains. Selling will immediately result in a tax hit, likely in the 21 per cent range (depending on your tax rate). Now, suppose like in our second point the market does rise another 15 per cent. With bid/ask spreads and commissions, (selling and then re-buying), you might lose another one per cent. Thus, your portfolio might be 37 per cent (21+15+1) worse off with your ‘brilliant’ sell-before-the-recession call than it would be simply by doing nothing. Even the 2008/09 financial crisis was barely that bad. And, of course, these costs — at least the taxes, anyway — are there whether your market call is right, or wrong. Thus, selling is really only a guaranteed way tolose21 per cent.

A recession. Really? Who cares? 

Any investor with more than a five-year time horizon really shouldn’t care much about a recession. If you don’t have a time frame of at least five years, then maybe, just maybe, you shouldn’t be in the stock market at all. A recession is part of a normal business cycle. They happen. Yet the market keeps marching higher over the decades. Even the ‘bad’ recessions are nothing but blips on a stock market chart moving higher and to the right. A worried investor is a bad investor. Plan your portfolio for a five-year term, minimum, and forget worrying about all the ‘noise.’

Certain sectors can do very well

One common thread in (recent) recessions is that interest rates peak, and then come down. Both the Bank of Canada and the Fed have already indicated that interest rates are not likely to rise anymore. What does this mean for investors? Well, all those preferred shares, bonds and dividend stocks that have been beaten up over the past three years while rates were rising are likely to start doing much better. Telecom companies, utilities, and consumer staples stocks tend to outperform when a recession hits. But lower interest rates tend to help out all income-stocks. Nothing is guaranteed, of course, but our bet is all of your dividend stocks that haven’t done a whole lot recently are about to boost the overall returns in your portfolio.

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