1- and 2-Year Yield Curve Inversion. Should we Worry?

Changes in the yield curve have been in the news when an “inversion” occurs; when shorter term bonds have yields higher than longer term bonds. Without getting into the math, yield curve inversions tend to precede recessions since Fed tightening at the short end (higher rates) reduces demand for credit thus causing lower rates at the longer end.

Another perspective on yield curve inversions has to do with forward rate math; the idea that a string of interest rates indicates what rates in the future will be. Without getting into the math, forward rates are not very predictive, except over very, very short time horizons. Though I respect the bond managers at PIMCO, I think they have it wrong here during this Bloomberg interview; they might be right, but I would not bet on it!


Thoughts for a New Year

Markets will be volatile, but we expect to be compensated for bearing the volatility. As long as we are comfortable with our risk profile and have a long enough time horizon, negative returns will recover (or, at least they always have!!). Accounts with more risk, over time, will out-return less risky accounts.

The book “The Rational Optimist”, by Matt Ridley, goes into great detail explaining how society has historically always figured out how to get past adversity. It is a good read if you are looking for some positive reinforcement in the New Year.

Positives and Negatives into 2019

Randy Brown, the current Chief Investment Officer at my prior company where I spent 25 years, Sun Life Financial, posted some observations on Forbes that highlight the potential positive and negative factors to be aware of as we enter 2019. Nice list, without undo hyperbole or alarm. Well-balanced and thoughtful.

On balance, there are warning signs, but no reason yet to run for the hills. The recent stock sell-off has priced equities attractively and corporate bond spreads are reacting favorably with spreads lower than recent historic (indicating less concern about default risk). Trade could be a wild card.

For more detail, check out the full post here:


The Sum of Its Parts

The S&P 500 index is made up of a select collection of the 500 largest stocks in the U.S. market based on market capitalization (shares outstanding times market price).  Though it is mostly a rules-based index, a selection committee is involved to ensure that it contains a combination of stocks and industry sectors that represent the broad U.S. economy.  In fact, just this year, the S&P 500 was changed to re-classify some highflying technology stocks (i.e., Alphabet (GOOGL), Facebook (FB), Twitter (TWTR)) from the Technology sector to the Communication Services sector.  Likewise, some Consumer Discretionary stocks (i.e., Disney (DIS), Netflix (NFLX), and Comcast (CMCSA)) were reclassified into the Communication Services Sector. 

The S&P 500 index is tracked closely by market watchers and its return profile is simply the sum of its parts.  A convenient way to understand its performance dynamics is to look at the return profiles of its underlying sectors.  The SPDR ETFs, ETFs that mirror the stocks held in the S&P 500 sectors, are a good way to get investable market exposure into the sectors.

As is usually the case, the return profiles of the 11 component sectors of the S&P 500 have been diverse through December 27, 2018.  As seen from the table below, the Energy sector lagged the rest of the market with a -18.01% return so far in 2018, whereas the Health Care sector outperformed all sectors with a +4.61% return.   The broad S&P 500 showed a total return so far at -5.26%.

Name Ticker Return % Percentile

Energy Select Sector SPDR® ETF XLE -18.01 11

Materials Select Sector SPDR® ETF XLB -15.11 24

Industrial Select Sector SPDR® ETF XLI -13.86 42

Financial Select Sector SPDR® ETF XLF -13.84 34

Consumer Staples Select Sector SPDR® ETF XLP -8.44 16

SPDR® S&P 500 ETF SPY -5.26 27

Real Estate Select Sector SPDR® XLRE -2.88 7

Technology Select Sector SPDR® ETF XLK -2.36 47

Consumer Discret Sel Sect SPDR® ETF XLY 0.50 10

Utilities Select Sector SPDR® ETF XLU 3.52 38

Health Care Select Sector SPDR® ETF XLV 4.61 16

Communication Services Sel Sect SPDR®ETF XLC na na

Many other things can be deduced from a table like this.  For example, an interesting dynamic from the table above is the relative performance of each of these investable sectors when compared to their peer groups.  Each of the SPDR sector ETFs, even the ones with negative performance, have outperformed their respective peers with above median performance (percentile rank less than 50).

Many market practitioners have studied the relationships between some of the sectors to see if there are any predictive qualities in the relative performance.  Many investment firms, including a New York firm named Pension Partners, manage tactical allocation strategies that look for trends in sector returns to manage portfolios.  The Pension Partners model (ATCIX) uses relative strength in the utilities sector (a traditionally “defensive” sector) to manage it strategy.  YTD that investment has produced total return of -11.06% compared to the S&P of -5.3%, so that strategy has not worked too well this year. Others in that space have faced similar problems, such as Newfound Risk Managed Sectors (NFDIX) at -7.72% and Good Harbor Tactical Core (GHUAX) at -7.42%.

Volatility Takes Center Stage

The fourth quarter of 2018, through December 26, has been a “bear”.  Despite a crazy record-breaking 1,000-point rally on the day after Christmas, preceded by a 600-point drop on Xmas eve, the S&P 500 still shows about a -6% total return loss on the year; with Q4 producing a -15% loss all by itself!

All major asset classes, not including cash, produced negative returns during 2018.  Emerging markets and international developed markets, the favorites of thought leaders for 2018, came in last at about -15%.  Small cap U.S. equities were down about -12%, REITs were down -7%, and even gold was down -3% (despite strong Q4 of +6%).  Bonds were least hurtful with broad bonds only slightly negative at -1%, but short Treasuries showed positive +1% returns.

Leading into the market open on December 27, futures point to a -1.5% retracement after the 1,000 point rally.  Expect more volatility into January as most portfolios get rebalanced back to targets after equity losses.  Selling bonds and buying equities, to get back onside, could prompt a pop in January, but underlying fundamentals should still lead the way.  We are watching the January 3 PMI (and LEI) for confirmation that the economy is still stable.


Tony Ash

December 27, 2018  8:40AM

Trading Places


The worst Xmas Eve stock market performance, ever - that is what CNBC commentator Bob Pisani reported.  Certainly, it was an eventful way to cap off the past few days of selling going into the last trading days of the year.


Utilities, one of the last sectors of the market to hold onto some semblance of rationality, got pummeled in today’s shortened session, down -4.2% (XLU) whereas previously pummeled financials were down only -2.1% (XLF) and the S&P 500 was down -2.7%.  High div stocks were indiscriminately torched with VIG, VYM and DVY, the three largest dividend-paying ETFS down -3% or more.  SPHD, the low vol ETF with a curated collection of the 50 least volatile stocks in the S&P, likewise got thrashed with a daily return of -3.4%.  Bonds continued their (mostly) negative correlation to equities with the AGG ETF flat on the day and long treasuries (TLT) up +0.5%.  Bonds with some equity exposure, though, were hurt with high yield and bank loans both down about -0.75% on the day.


Despite the media proclaiming all of the root causes, including political dysfunction, tightening Fed, and trade wars, all of these factors have been with us for quite a while and did not cause the pain we are seeing until the beginning of October.  Yes, a tightening Fed is likely to cause slower growth in 2019, but not to the extent that the markets are discounting.  In fact, most government statistics and corporate earnings results continued to show positive signals; the weakest signal we have seen is the trading momentum; which is like saying “the market is weak because the market is weak”.  The inverted yield curve between 2s and 5s is likely only a supply/demand artifact that includes influences from overseas markets and is not in and of itself an indicator of a pending recession.


In the face of huge market weakness, it is not reasonable to be bullish.  But, until we see more signs that something fundamental has changed (e.g., a weak PMI or LEI stat), we cannot be certain that we have entered a market with a larger prolonged downdraft.  In the absence of that, I continue to be cautious but hopeful that the fundamentals will rule the market trend and resume an upward bias.


Tony Ash


Market Volatility Update: December 21, 2018

More pain in the market this week with S&P down -6%.  Though it is safe to assume we will get some slowing in the economy due to this hawkish Fed, we can’t be convinced that it will translate into a larger drawdown (like 2008-09) until we see some other signs.  I (almost) never make market calls, except in the case of a market crisis that leads to a large and long drawdown.


We have two factors currently telling us that the potential of a larger drawdown is possible:  weak price momentum and the yield curve tending to invert (2s-5s; though 2s-10s is better indicator).  Other factors that we look at are still positive such as Purchasing Managers Index (“PMI”, still growing, though less so), Leading Economic Indicators (ditto), and “Financial Turbulence” (a sophisticated measure, but generally flashes a warning sign when returns, correlations, and volatility start deviating from norms; still ok).  Some other factors pointing to “risk off” include relative strength in defensive sectors like Utilities (yes) and Treasuries (yes).  If one or two of the factors turn negative, we could be in for a larger protracted drawdown; we won’t know that until January 3 for the PMI release.  In that case, and depending on the specific client situation, I could be inclined to move some client assets into long maturity bond ETFs or cash, depending on what is driving the dive.  We would get back into the market when the indicators turn positive which could take months!

When is $1 million NOT $1 million?

By now, most every media outlet has run their own take on the GOBankingRates study on how far $1 million will go in retirement in each state.  The study looked at the cost of normal expenditures for the average 65-year old including things like groceries, housing, utilities, etc.  They then factored the expenses by the cost of living index in each state.  Not surprisingly, Hawaii, California, Alaska, New York and my home state of Massachusetts are the most expensive and Mississippi, Arkansas, Oklahoma and Michigan are the least expensive.

Thankfully, some media outlets, including Bloomberg and Huffington Post, thought to question some glaring omissions in the study, but others including CNBC and USA Today merely “parroted” back the results.

The problem with studies like this is that they inevitably rely on averages and ignore the fact that personal situations are the most important factor.  For example, housing costs based on current market levels are mostly irrelevant for a 65-year old who has paid off their mortgage and has no intention of moving, though taxes and upkeep would still be a factor.  Likewise, no reference is made to future inflation or inflation specific to how a person currently or prospectively would spend their money.  Also, no reference is made to expenses for entertainment or travel.  However, the biggest gap in the study is the lack of details related to taxes.

The study seemed to imply that the fictitious 65-year old had $1 million in cash in a checking account to pay their bills.  Of course, if the $1 million was in a retirement account (401-k, IRA, or similar) all withdrawals would be taxed as ordinary income with the requisite income tax liability, depending on the personal tax situation.  Hopefully, this person has other income to pick up the shortfall due to the income tax liability.

It seems that every time we read a story about “your number,” the tax aspect is ignored.  This is certainly due to the difficulty in capturing all the brackets, exemptions and nuances in the U.S. tax code.  However, we at least need to grasp a simple view of the matter so as not to misstate the situation.  In fact, assuming a modest 15% marginal tax bracket (up to $75,900 for married filing jointly) and 5% state tax rate, your $1 million is worth significantly less in spendable cash once it is withdrawn from tax-deferred accounts. 

In round numbers, the $75,900 maximum annual income in the 15% bracket is only worth about $60,720 (75,900*0.8 Federal/State tax) in after-tax income each year from a tax-deferred account.  Withdrawing more would bump you into a higher bracket and provide a progressively lower amount of net income after tax.  In round numbers, $1 million sitting in a tax-deferred account is worth only about $800,000 of net income if you net out the $200,000 that would be due in taxes from annual withdrawals of $75,900 over a 13-year horizon.  For simplicity, I left out the interest-on-interest component; but, assuming a 3% annual return the time horizon would be extended by 4 years.

Tony Ash, 8/29/2017