The yield curve, low rates and the less efficient market hypothesis

1) What deradicalized you?

I really liked this question from Joe Weisenthal on Twitter:

I started investing during the Nasdaq bubble and was immediately thrust into a brutal 3 year bear market. And then the real estate bubble expanded, too became very bearish on the economy around 2006. Then the financial crisis happened and I became even more negative about everything. All of my early investment experience was trial and error. The generally optimistic Cullen you may have known until now did not exist. But around 2011/12, I got tired of living in fear and realized that very few people make money being pessimistic over the long term. And it was also around this time that I realized that most of the bear narratives were completely wrong. All that scaremongering about national debt, QE, valuations, capitalism etc. They were mostly clever narratives that were designed to scare people to buy someone’s political narrative or newsletter.

And during this time I was “derradicalized” in the sense that I made a concerted effort to look at the world through empirical evidence and not through emotion. I wrote Understanding the Modern Monetary System and wrote thousands of blog posts at Pragmatic Capitalism, debunking nonsense narratives using a first-principles approach to understanding the financial world. I promised myself that I would create empirical, evidence-based understandings of the world that would serve as the foundation for every investment decision I made in the future.

I think the big takeaway from this is an important one: it’s okay to be skeptical about things. It is healthy. But skepticism and pessimism should never dominate your long-term investment thinking. Optimism with a healthy dose of skepticism will yield far better results than living in fear or moving from fear to hope.

2) The yield curve turns off

Here’s an interesting chart from Goldman Sachs that shows the history of market returns after turning off the yield curve. Yield curve inversions have been a constant concern for many investors in recent years, but it is interesting to note that recessions usually occur after 7 months. after the curve normalizes. This makes sense when you think about it, since the Fed usually starts cutting when things start to soften. And, as Goldman notes, the difference in market returns between recessionary and non-recessionary environments is significant.

I never love such data sets because 15 data points is not enough to generate a statistically significant result. But I think this is an interesting historical look at returns given the current environment. The Fed is currently in the overshoot period for the so-called soft landing. As we’ve noted in recent articles, the next 9 months will decide whether the Fed can cut rates of its own accord, or whether the economy will force them into an emergency landing where they cut rates to avoid a recession.

So I think the takeaway from this is the same as what I’d always say about short-term stock market investing – it’s always risky to bet on a long-duration instrument in the short-term, and I’d also argue that this environment is riskier than average because the market is so optimistic about a soft landing.

3) The less efficient market hypothesis

I love this new work by Cliff Asness. Cliff argues that the market has become less efficient over the past 30 years due to three main factors:

1. Indexing has ruined the market
2. Low interest rates have ruined the market
3. Technology is disrupting the market

Cliff puts number 3 as the most important factor. I have argued many times that the low rates were just a function of low inflation and the impact of indexing was overstated because even indexing is more “active” than the binary representation that is often portrayed. But #3 is really interesting, and I think it could explain a lot of what’s happened over the last few decades as more retail investors and algorithms have become prominent in the markets. Everything became a little more emotional and hyperactive. But the most interesting part for me was Cliff’s main takeaway:

1. Having a long time horizon is the closest thing to an investor superpower.

I’m not a huge supporter of factor investing in the sense that Cliff is, but I absolutely support his conclusion. Stocks, in my fixed-duration methodology, are 15+ year instruments. Picking the best factors, sectors or stocks within that time horizon will be difficult. And rather than own parts of the market, I generally prefer to own the whole haystack, as John Bogle always said. There is nothing wrong with tilts and certain levels of activity like rebalancing, but being patient is truly the ultimate stock market superpower.

By the time you read this, the market will be overreacting to short-term movements in a jobs report that will be revised and then revised and then revised again over the coming months and year. But you can guarantee I’ll have some thoughts on it over the weekend. Until then, stay disciplined!

Original post

Editor’s note: The abstracts for this article were chosen by the editors of Seeking Alpha.