What To Do About Inversions
The Federal Reserve is raising short-term rates, inflation is rising, and a war is happening in Europe, all of which are concerning to investors.
We have written about these challenges in a piece titled Inflation – What An Investor Should Do and a post about Ukraine called The Normal Steady Hand. Both speak about the fact that history has shown consistently that the best course of action is to avoid changes to long-term strategic plans and to stay the course.
Even though these conclusions from independent researchers have been documented over multiple market cycles, you would not know it from concerning headlines and forecasts that prompt calls to action.
The latest issue making investment news is what is called an Inverted Yield Curve, which happens when the yield on short-term bonds moves higher than the yield on long-term bonds.
This just happened and is drawing attention because, in the past, it has been a harbinger of recession and equity market drops.
The question is…
What do we do about it?
First, even though yield curve inversions can suggest that a recession may be ahead, as with other so-called signs, Fallible Forecasts are the norm.
Second, an investor seeking to get ahead of what may or may not happen in the future has to call both exit and re-entry points correctly and, unfortunately, we’ve never met or read about anyone being able to time the market well. Research shows that it is truly a loser’s game.
These cautions do not mean that we shouldn’t consider new findings, however, or continue to look for opportunities to add value.
In this vein, we recently reviewed a 2019 paper by the Nobel Prize winning economist Eugene Fama and his colleague, Kenneth French, called Inverted Yield Curve and Expected Stock Returns.
In their study, Fama and French tested data from twelve countries over the period 1975 – 2018 to assess whether equities underperformed money market funds following a yield curve inversion. They were looking to determine the following:
Does it pay to tactically sell or underweight equities after a yield curve inversion?
Their answer is consistent with that of other research on this question.
No.
Fama and French found “no evidence that yield curve inversions can help investors” time the market, as such inversions do not accurately forecast if equities will underperform.
So, circling back to the “What do we do?” question, our advice remains the same.
Make sure you have a sound, well-diversified, long-term investment plan that aligns with your goals and makes you feel comfortable. Then, stick to it.
Put a written Investment Policy Statement (IPS) in place before any investment plan or product is implemented. Emphasis on “before”.
An IPS does not have to be complex.
It can simply establish long-term targets for various asset classes, and maximum and minimum risk control ranges around the targets. This way, regardless of the latest headline or forecast, investors can keep from making big bets that could turn into big mistakes.
As an example, an investor with a long-term IPS target of 60% in equities might consider having a range with a low end at 55% and a high end of 65%.
If the market were to drop significantly and the equity allocation were to fall below the minimum range, the IPS would mandate that the investor buy. On the other hand, if the market were to run up significantly, crossing the upper limit of equity exposure in the range, the IPS ceiling would force selling to take some chips off the table.
Yes, investors could instead try to time the market or find managers who can outperform, but, as we have documented before, both of these games are exceedingly hard to win consistently over time.
The best investors understand that they will be wrong – often – and don’t try to time the market.
They don’t invert plans based on economic or market forecasts.
They exercise the fortitude to stay on plan, especially during troubling times.
Because…
History and countless studies continue to show that successful investing comes from simply establishing a plan and sticking to it.
Related Reading:
Should We Be Tactical? – Elisabetta Basilico PhD, CFA
Fallible Forecasts – Maneesh Shanbag, CFA
The Same Thing – Over and Over – Preston McSwain
Inflation – What Should We Do? – Elisabetta Basilico, Phd, CFA
The Normal Steady Hand – Preston McSwain
The Simple Alternative – Charlie Henneman, CFA
Staying Disciplined and Avoiding Unforced Errors 