Many are saying that the recent weakness in small-cap stocks is an indication that the economy is about to enter a recession. However, value investors believe it’s foolish to look towards the market for advice on the economy. Instead, we view the market as a potentiator of stock-buying opportunities. Rather than the market, we watch employment statistics and the yield curve. Those two economic indicators have a 100% accurate record of predicting downturns since 1932.
Unemployment continues to drop and after last month’s 288,000 increase in jobs, the unemployment rate has reached a five-year low of 6.3%, dropping from 10% in early 2009. We would need to see a couple of month’s reversal of that trend to signify an economic downturn.
Chart 1: The unemployment rate continues to drop as the economy strengthens. Courtesy of Bureau of labor Statistics.
The Yield Curve is the difference between the yield on 3-month Treasury Bills and 30-year Treasury Bills. A steep yield curve indicates that investors are not yet piling into short-term bonds in an effort to avoid an economic downturn. A flat yield curve indicates that investors are buying up the short-term bonds, and the demand has forced yields as high or higher than long-term thirty-year bonds.
Chart 2 below shows the flat yield curve at the end of 2007, just before the 2008 recession hit while Chart 3 shows today’s yield curve which is about as steep as it has ever been. You can see an animated version of these charts for 1999 to present at StockCharts.com.
The yield curve goes flat when the economy is overheating, and smart money recognizes that fact, moving money into the safety of bonds. However, instead of growth that causes overheating, we see steady growth of about 2.5%, accompanied by low inflation. Today’s economy is about as good as it can get: slow but steady growth with no signs of overheating, the perfect combination for long-term value investors.
Chart 2: The yield curve before the last recession was almost inverted.
Chart 3: The yield curve today is still very steep.
Having said all that, it has been three years (2011 debt-ceiling fiasco) since we have seen a surprise-shock to the economy, and we are overdue. The corporate profit margins, as well as the Graham 10-year PE ratio, are also at historic highs and can’t remain there forever. Therefore, we will maintain a conservative posture and continue to use fixed stops (on a closing basis) at this time. We will be taking those stops off as soon as we see confirmation of the market upturn discussed below.