A Historic Tuesday: Meltdowns & Yield Curves

I’m moving the normal Friday post to Thursday this week to talk a bit about recent developments in the market because lord knows we’re all just refreshing Bloomberg and CNBC all day anyways. As of Tuesday, its officially now an inverted yield curve world and we are all just living in it. Since this blog has an almost messianic obsession with the yield curve, Tuesday was needless to say an exciting day in the Fat Tailed & Happy household. At the same time (which is rather obvious since all economic variables are interrelated), the Dow Jones dropped nearly 800 points.

The Inverted Yield Curve

inverted yield curve

For the first time since the Financial Crisis, the 2-year to 5-year portion of the yield curve inverted during Tuesday’s trading session. While this particular combination of securities is not the typical 2/10, 10/20 or 3 month / 10 more well known, it is nevertheless rather worrying and reflective of some serious underlying stresses building in financial markets. Historically, this spread correlates rather well to its more well known and loved big brothers. On average, this spread inverts somewhere in the vicinity of 12 to 24 months before the beginning of a recession:

A Ho-Hum 3.2% Down Day

Despite the massive headline number, Tuesday’s 800 point drop on the Dow Jones Industrial was a modest 1 in 100 type of percentage down move. In fact, if you found it remotely heartburn inducing, there were 19 trading sessions in 2008 with a greater downward move. Hell there were 10 times in 2008 the market dropped more than 5% (which would be ~ 1,300 points on the Dow right now):

a super shitty year

If the markets have you reaching for the Tums, perhaps it is time to revisit whether or not your allocation is truly appropriate.

The 2000 Recession

I will have a longer post about this in the near future, but I see a cavalcade of posts recently talking about 2008. Hell, I just talked about it above. But the posts I’m talking about usually advocate 2008 as a lesson for why selling is a bad idea.

2008 was the financial equivalent of a rogue wave. We were all chilling on the SS 2007, enjoying some cushy drinks and laughing at all of the people that were leveraging their homes to pursue some bullshit HGTV channel house flipping dream career. Little did we know that off in the dark foggy distance, a massive maelstrom lurked. It crashed into the ship, flipped it over, and it really wasn’t looking too good for awhile. But things stabilized. The selloff and the panic were sharp, but so was the recovery. Pretty soon we were all high fiving around bottles of champagne in the hot tub.

But 2000? That was the real, pure, unadulterated asshole at the party. Most of the FIRE bloggers out there are too young to remember the 2000 recession. If 2008 was a rogue wave that was sharp and sudden, 2000 was a tsunami that simply beat the shit out of you through its relentless body blows of pain. 2000 did not sell off particularly quickly, but it took several YEARS for a bottom to be put in. Forget ‘return’, it took over a DECADE to permanently even break-even. And I’m talking nominal break-evens. Yes, you got all of the drama of the 2000s and the 2007 financial crisis and in exchange you got a massive inflationary loss.

The returns from being invested in 2000 to this date are STILL so shitty that you could have clobbered them by nearly 2% by just buying a 20 year bond and holding it.

yield curve inversion

2000 was the suck

I mention it because the current market environment looks an awful like 1998 or 1999 to me. People buying dumb shit like crypto and continuing to lend tech darlings oodles of money and giving them ridiculous valuations. We knew valuations were stretched in 2000 and sure enough the returns bore it out:

valuation vs forward return

I reckon the next recession will closely resemble 2000: a mild economic event but a real pain in the ass for anyone that goes plowing full tilt into it leveraged in equities.

Defcon 2 For Investments

Defcon 2 is a Cold War era expression. You know the vintage poorly colored films where the US would keep the B-52’s fueled and armed to the gills with nukes ready to end the world if things got a little worse, and they’d practice drills as everyone freaked out and sprinted full tilt to the aircraft. People sat around on submarines with big fingers on little red buttons ready to unleash Armageddon.

For my personal investments, Tuesday was a bit of a move to “Defcon 2” positioning. It now seems far more likely than not that a recession will hit the US economy at some point in the next 2 years. As I write this (Wednesday evening), Dow Futures are off nearly 300 points and the 10/2 spread sits at single digits.

As I mentioned last Friday, I’m growing concerned about a few things in the economy. The inversion of a portion of the curve combined with a very weak 10/2 spread has me mentally thinking through final preparations of all the hatches to batten down for my portfolio. I’m not bailing entirely yet (that would be ‘Defcon 1’), but my already cautious allocation will begin moving towards higher credit quality issuances, lowering equity exposure, and generally trimming up loose ends on any strength we see from here on out.

I don’t recommend any particular course for anyone (because nothing on this site is advice, it is purely all for your own information and amusement and yes, that is a disclaimer). But it might not be a bad time to do some soul searching over how you’d like to play a business cycle downturn. If history is any guide, we have some time still to make our final arrangements.

 

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