Yield curve inversions… geopolitical crisis… the start of a Fed tightening cycle… There’s plenty of fodder for mainstream media pundits to garner attention, but is this really the right time for sensible investors to cut and run?
There’s nothing like a 13% correction in the S&P 500 and a 20% pullback in the NASDAQ to get the doom purveyors excited. And indeed, when stocks are falling fast, it’s certainly tempting to pull the plug to avoid further losses.
Those indexes have retraced their corrections somewhat, but the overall results for 2022, so far, are still negative. It’s still conceivable that any 5% or 10% retracements are only head-fakes or bull traps within a larger market crash.
So, let’s break down the currently perceived threats to the stock market. Sophisticated traders often watch the 10-year U.S. Treasury bond yield as well as the 2-year Treasury yield. If the former exceeds the latter, it’s believed that this is a sign of trouble ahead.
As I pointed out previously, there is evidence that yield-curve inversions have historically preceded recessions since the 1950s. On the other hand, Ryan Detrick’s research found that in the four times the 2-to-10-year yield curve inverted, the S&P 500 rallied for another 17 months and gained 28.8% until the final peak occurred.
Therefore, it’s entirely possible that the 10-year yield could plunge below the 2-year yield – which is a strange and hard-to-explain occurrence, admittedly – and the stock market might continue to rally for a year and a half.
Still, it’s understandable if investors are daunted by this yield curve inversion chart, provided by the Federal Reserve itself:
Courtesy: St. Louis Federal Reserve
Twitter user @FinanceLancelot observed that the current yield curve inversion in progress (we’re not there yet, but it’s likely to invert in the near future) is fast. Whether the speed of the inversion is meaningful for future stock market returns is debatable, though.
Hence, we can call the yield curve inversion threat “inconclusive.” Next, there’s the news development that has dominated the non-financial headlines for a full month now: Russia’s invasion of Ukraine (even if it’s not formally recognized as an invasion by the Russian government).
As a 40-mile Russian tank convoy rolled into Ukraine in late February, Kirk Spano boldly predicted that the Ukraine situation won’t matter to stocks in a month. This, of course, wasn’t dismissive of the loss of life. Rather, it was a statement on Wall Street’s ability to acclimate to geopolitical conflict after a while.
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I’ll let you decide whether or not Spano’s prediction was vindicated, but the stock market did stage a pretty impressive recovery within a month’s time. Indeed, having a “this, too, shall pass” attitude has paid off handsomely for investors during various crisis situations, including the March 2020 onset of Covid-19 in the U.S.
Looking ahead, the Russia-Ukraine situation could take a while before there’s a resolution. Still, it appears that the markets have adapted pretty well to the ongoing conflict in eastern Europe, and even to the reality of persistent inflation that’s been exacerbated by that conflict.
As a side note, some folks simply feel that stocks are doomed because they recently corrected, and that’s how bear markets start. Now, it’s certainly true that every 20% crash must be preceded by a 10% correction. However, most corrections don’t turn into full-blown crashes – and buying the dip has been a surprisingly solid strategy in the past.
Using data that goes all the way back to 1928, it’s been found that the S&P 500 has had a median gain of 11.5% one year after exiting a correction. Moreover, the average post-correction gain has been nearly 14% – a good S&P 500 result for 12 months.
Finally, there’s the concern that the Federal Reserve’s shift to a tightening cycle will send the economy into a recession and, consequently, the stock market into a downward spiral. Bank of America strategists recently alluded to this concern, along with the Russia-Ukraine crisis, when they wrote, “The worsening macro backdrop and market-unfriendly Fed make sustained U.S. equity gains unlikely.”
But then, these are already known and priced-in factors. The financial markets in the 2020s are remarkably efficient, and big banks are fully anticipating interest-rate hikes at every FOMC meeting this year, including at least a couple of 50-basis-point increases.
I could always be wrong, but I suspect that a completely new, major, negative surprise would be needed to turn the recent stock market correction into a bear market. Trying to predict a market crash is difficult – and missing out on gains for the remainder of the year would be a real shame.
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