3rd Quarter Client Note – Yield Curve Ball

By Steven Smith | Investment Management

Oct 11

The S & P 500 (total return) Index experienced its best quarter in five years, rising 7.2%. (Of course, things happen so fast, that as of this writing the S&P 500 has fallen almost 4.5% in the first nine days of the third quarter; led largely by falling technology stocks and possibly attributed to the effects of a trade war and rising interest rates.)

But it was another disappointing quarter for investors tilting toward small cap stocks and value stocks; as US Large-Cap Growth returned 9.17% and US Small-Cap Value returned only 1.60%. Although leadership in the Large Growth category may be shifting, with Facebook (one of the FANG’s) falling 15% and Twitter dropping 35% amidst talk of Congress perhaps regulating social media companies.

Foreign stocks lagged considerably, with the MSCI Developed Market Index rising 1.35% and the MSCI Emerging Market Index falling 1.09%.

In the fixed income market, the Barclays US Aggregate Bond Index rose a meager .02%. The Fed raised the discount rate in September by another quarter percent to 2.25%.

The Quarterly Market Review from our friends at Dimensional Funds Advisors contains a comprehensive review of the third quarter’s results.

Ten Years After (I’d love to change the World)

This fall marks the ten-year anniversary of the depths of the global financial crisis. On September 15, 2008, Lehman Brothers – the fourth-largest US investment bank – filed for bankruptcy. On September 28, Congress rejected a $700 billion bailout of the financial system. In response, The Dow dropped 778 points (6.98%.) Then, on October 2, Congress reversed itself, approving the package.

Whither the Yield Curve?

Economists love to stare at the yield curve – like a ouija board – looking for signs of the next recession. The yield curve is an x/y axis chart depicting the relationship in the bond market between interest rates on the y axis and various maturities on the x axis.

A “normal” yield curve is positively sloped and shows short-term rates being lower than long-term rates, with investors expecting to receive a “term premium” for taking the risk of tying up their funds for a longer period of time. On rare occasions, the yield curve “inverts” and becomes negatively sloped. Typically, as has happened recently, this occurs when the Federal Reserve Bank raises short-term interest rates in response to a strengthening economy and longer term rates don’t catch up because investors believe rates shortly will be falling. Sometimes this is a precursor to a recession. But there is no reason to panic.

First, while an inverted yield curve has historically been a reasonably good recession predictor, economists have recently been hotly debating whether this time may be different and whether the flattening yield curve is about to invert and whether a recession is imminent. Second, even if the yield curve were to invert, there is not a particularly strong correlation to future equity returns.

And, finally, for better or worse, longer term interest rates are finally rising, postponing, at least for now, a yield curve inversion.

Diversification is Supposed to be Hard

The essence of diversification – combining into portfolios asset classes with different sources of returns – is that you are always going to have an average return that is worse than the best returning asset class and better than the worst. This is the price we pay for not being able to predict which is going to be the best performing asset class in any given period. Economists and market prognosticators all have terrible records in forecasting the future direction of the economy and of markets. And the science of behavioral economics informs us that relying on our instincts may be even worse.

But obtaining average results is a reward for good planning; for recognizing that we don’t need the returns of the highest performing asset class to achieve our financial goals.

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