My Thoughts on the Yield Curve Inversion (3m/10yr)

So it finally happened. The “most reliable recession indicator is finally flashing red.”

Last week the 10-year yield fell off a cliff and dropped below the 3-month yield for the first time since 2007. Gasp! That was just before The Great Financial Crisis. Data from the National Bureau of Economic Research tells us that the yield curve has inverted before each of the last seven recessions. (This time the inversion was brief- only part of a day) Many analysts firmly hold the belief that the yield curve is the best forecasting tool for recessions. Yes, that is true, I suppose. So now what? Is it time to sell out of the markets? Should I put my feet up and sit back on the sidelines waiting for stocks to fall? What if they don’t? If they do, when should I re-enter the market? The answers to these questions presume that I know when, exactly, a recession is coming and how bad it is going to be. Truth is, I have no idea.

Even I could tell you, without any economic data at all, that we’re going to have another recession. In fact, I guarantee we will. There might be (probably will) multiple in my lifetime. How does it make sense that the price of borrowed money (because that is what interest rates are) in 3-months is more expensive than 10-years? The answer is complex and I’m not about to turn this post into an essay in an attempt to explain it. But I’m sure many of your friends and colleagues know exactly what is causing the inversion and what to do about it. However, unless your friends and colleagues are noted economists, I am skeptical. Even if they are, well, given economist track records, I am still skeptical. Did you know economists have predicted 7 out of the last 5 recessions?

So what am I going to do about it?

Nothing.

I’m not going to rush to judgement and assume a huge recession is right around the corner and that equities are going to come crashing down in a fiery ball of fury to reign hell on my portfolio and turn my cash to ash. This would be an emotional response to new information. Emotions are an investors biggest foe. I will not sell out of any positions unless I believe the decision is warranted based on fundamentals. Nor am I going to rush into cash or buy more gold. Why? Because I am a conservative, value investor that is structuring an equity portfolio so that its manager (me) can ignore what is happening in the broad market. In other words, I intend to keep my portfolio ready for a recession (more specifically-a stock market crash) at all times. There’s mainly two ways I do this.

1.) High liquidity.

I will admit, in a slightly hypocritic way, as someone who says they do not try to “time the market”, I do tactically adjust my cash position based on the over/undervaluation of stock prices. Usually this happens naturally, such as right now, where I am finding it difficult to find investments that warrant my hard earned money. The dividends keep rolling in, I do my best to remain consistent in putting aside money each month, and I have not found opportunities to re-invest. But the point here is that I always keep a cash buffer. Currently at ~17% of the satellite portfolio, my cash position is on the high end since inception. I hold a cash position that I can deploy when I find opportunities that fit what I deem to be strong investments. Currently, I can’t find any! I think most value investors are having the same issue and, as a result, my cash position continues to grow.

2.) Bottom-up Fundamental Analysis.

Said another way, I am not making bets based on macroeconomic or geopolitical factors. The inversion of the yield curve is not part of my decision making process. Neither are trade tariffs, political uncertainty, GDP forecasts, nor the undertones in Jerome Powell’s speeches. Sure, I follow these items. I read the WSJ on a daily basis. I have my thoughts on the economy, different asset classes, and even the yield curve inversion. But this is done for no other reason than to help build context of the investment environment I am operating within. I try to be aware of all sorts of risks, but if I made trades based on how the newspaper made me feel about the economy, I would constantly be making trades. Execution costs would have zeroed-out any investment returns. I look at each investment opportunity on a stand alone basis. I look for a sustainable competitive advantage that can withstand a recession and an incentivized management team, amongst many other boxes that need to be checked. Then I calculate the value of a company and compare it to the price, only buying when there is a significant discount. This “margin of safety” is intended to protect my portfolio against broad market drawdowns. Strong companies will continue to do business regardless of a recession and the stock market will fluctuate regardless of what the economy is doing. What matters to me are finding companies that provide a good or service that will be in demand even if the economy comes to a screeching halt. But even more important, is buying these companies when they’re cheap. I already mentioned that I’m finding it difficult to put my money to work. I would welcome a sale on the stock market.

So there you have it. My profound thoughts on the yield curve inversion. I’m not doing a damn thing besides continuing to scour the investment universe for the next addition. High liquidity, good companies, and a margin of safety should insulate the portfolio from irreparable mistakes. As a gambler would say, “make sure you can live to play another day.” I intend to. So bring on a stock market crash. I wont be swimming naked.

Uncle Pennybags

P.S. Where’s the term premium?