WHY SELLING ISN’T ALWAYS THE ANSWER AFTER INVERSION OF THE YIELD CURVE

Martin Pelletier encourages investors to keep their focus on playing the long game.

Last week, investors hit the sell button on risky assets including both stocks and oil as the 10-year U.S. Treasury rate dipped below the two-year Treasury rate for the first time in 12 years.

Whenever this has happened in the past, it has been followed by an economic recession that starts an average of 17 months later.

The catalyst for this latest inversion is the escalation of the ongoing U.s.-china trade dispute. There are also concerns over the economic outlook in other regions such as Europe and Japan, as evidenced by the Us$16-trillion worth of government bonds — representing 28 per cent of the total market — that are trading at negative yields.

All of these problems have resulted in a spike in equity market volatility with investors moving into safe haven assets including cash, long-term bonds and even gold.

However, during times like these, it’s imperative that one avoids getting caught up in the headline reporting and remains focused on playing the long game.

First, it really helps to realize that corrections are part of a normal functioning market. On average there are three corrections per year on the S&P 500 totalling more than five per cent. Some years have none, such as 2017, while others have more, such as 2018 when there were five. As Michael Batnick of Ritholtz Wealth pointed out, last Wednesday’s sell-off was the 307th time that the Dow Jones has fallen by more than three per cent in one day in the past 100 years.

It is also important to understand that economies and equity markets do not always move together. This phenomenon can be a bit perplexing as one would think a recession would impact corporate profitability and therefore share prices. However, multiple studies have shown that stock prices have actually done the opposite upon the inversion of the yield curve.

According to research by the Bespoke Investment Group, whenever the 10-year Treasury Note yield hit a 52-week low, average forward returns for the S&P 500 were higher the following day, week, month, three months, six months and year. Looking out longer term, data from LPL Financial and cited on Market Watch indicate the S&P 500 returned on average 13.5, 14.7 and 16.4 per cent in the one, two and three years following an inversion.

Now, this doesn’t mean that the current rout in equity markets is over, but the inverted curve also doesn’t necessarily imply that it will get worse. The bottom line is no one is able to predict nearterm moves in the market as there are too many factors at play that could have an impact either way. For example, any resolution to the U.s.-china trade dispute would be extremely positive to the markets.

So when it comes to positioning your own portfolio, the recent pullback should provide a good test of just how comfortable you are with the moves to the downside in order to capture the long-term upside potential. In the meantime, for those who happen to be underweight equities or considering reducing their position, consider this: Nearly three quarters of S&P 500 stocks offer a dividend yield higher than the current 10-year Treasury rate.

Here in Canada, many of our blue-chip equities including the banks, insurance companies and pipelines have dividend yields ranging from four to as high as seven per cent, as compared to the 10-year Bank of Canada yield of 1.2 per cent. In the energy sector, Canadian oil stocks are trading at their largest discount to oil prices ever, with many also offering dividend yields over five per cent.

We tend to look to the bond market as a means of managing the volatility in one’s portfolio while deploying a diversified approach to owning equities across various segments of the market and geographic regions. An added bonus is the very attractive tax-efficient dividend yields currently being offered in this low interest-rate environment — a bonus that looks set to grow as rates go even lower. Financial Post

Martin Pelletier, CFA, is a portfolio manager and OCIO at

Trivest Wealth Counsel Ltd, a Calgary-based private client and institutional investment firm specializing in discretionary risk-managed portfolios as well as investment audit and oversight services.

DREW ANGERER/GETTY IMAGES It is important to understand that economies and equity markets do not always move together, says Martin Pelletier. Multiple studies have shown that stock prices have actually risen upon the inversion of the yield curve, Pelletier explains.