Inverted Yield Curve May Yet Upend Stock Market: Caroline Baum
By Caroline Baum
bloomberg.com
Oct. 4 (Bloomberg) -- Stock prices and the Treasury yield curve enjoy a select status as two of 10 designated leading economic indicators. When they're predicting different outcomes, what's an investor to do?
The Dow Jones Industrial Average reached an all-time high yesterday. Corporate profits, the stuff of which stock prices are made (except on those rare occasions when they lose touch with reality), stood at a 40-year high as a share of gross domestic product in the first and second quarters of 2006.
While there's a good chance second-quarter profits, at 12 percent of GDP, will be revised down based on upward revisions to personal income, it's still premature to conclude that the era of big margins is over. And stock prices seem to be reflecting that optimism.
So why is the bond market so glum? Long-term rates have been consistently below the federal funds rate for three months, a harbinger of bad economic times.
They can't both be right, can they?
Let's look at the underlying dynamics of each market.
Now that housing is past its prime, corporate profits remain the brightest spot of the expansion, rising 18.5 percent in the second quarter from a year earlier, a touch above the average for the last four years, according to the Bureau of Economic Analysis. The BEA calculates profits, with an adjustment for depreciation and the value of inventories, for the universe of U.S. corporations on the basis of tax returns.
Since the fourth quarter of 2001, the official trough of the recession, corporate profits have doubled while nominal GDP is up 29 percent.
Long Leader
``Corporate profits are an important signal of the future direction of the economy, although they are also an indicator with relatively long leads,'' says Gail Fosler, chief economist at the Conference Board, a business research organization based in New York.
With a couple of exceptions, ``most recessions have been preceded by a well-defined turn in corporate profitability of three to seven quarters,'' she says.
On the performance of corporate profits alone, then, there is no sign of recession on the horizon.
However, it appears that ``non-financial corporate profits have peaked, and they're normally a leading indicator'' of overall profits, Fosler says.
Profits for non-financial corporations fell 3.6 percent in the second quarter from the first. It was the first decline -- excluding the Hurricane Katrina-related drop in the third quarter of 2005 -- since the first quarter of 2003.
Mid-Course Correction
If the inverted yield curve is right, and the economy is looking at a period of sub-par performance (Fosler's forecast), shouldn't stock prices reflect expectations of slower revenue and profit growth?
Not necessarily, according to Bob Barbera, chief economist at ITG/Hoenig, who sees nothing inconsistent about stocks and bonds doing well.
``To date, it's been a prototypical mid-cycle slowdown model,'' he says. ``The economy slows, the Fed is done tightening, bonds rally and stocks take their information from bonds as to how to value earnings.''
Because future earnings are typically discounted to present value using a risk-free rate, such as the 10-year Treasury note, ``falling interest rates allow stock prices to go up even in the face of an obvious slowdown for earnings,'' Barbera says.
Barbera points to previous periods when stocks struggled (1984 and 1994) in the face of strong profits because of the rise in long-term rates.
``Once Fed tightening is over -- and the Fed usually has to take a couple of those moves back -- the stock market focuses on lower discount rates rather than slower earnings,'' he says.
Sweet Spot
So far so good. Economic growth ``is slow enough to keep the Fed on hold, bring core inflation down and deliver respectable earnings,'' says Steven Einhorn, vice chairman of Omega Advisors, a New York hedge fund. ``It's the sweet spot for equities.''
If the inverted yield curve persists for several more months -- the Fed is unlikely to cut rates in the next few months and an increase in long-term rates remains a forecast -- it would reinforce the idea of recession next year.
Many analysts dismiss the yield curve signal -- it's different this time -- because they claim the why of the inversion is more important than the what.
Yet even if the why is a global savings glut, with Asian central banks recycling dollars into safe-haven Treasuries, it's still a case of more entities wanting to save at any given price (interest rate) than they did before. And that's not stimulative.
Safe-Haven Status
Perhaps Treasuries aren't the only safe haven. The U.S. stock market is playing that role too, according to Fosler.
The Standard & Poor's 500 Index is up 25 percent in the last five years and is ``the most undervalued of the global stock markets,'' she says.
Of 80 major world stock indexes, the S&P 500 and Dow were among the 10 worst performers since October 2001, according to data compiled by Bloomberg.
On a relative basis, U.S. stocks may be a bargain -- especially if the mid-course correction comes off without a hitch.
If, on the other hand, the yield curve inversion persists and deepens, the odds of a shipwreck will only increase. Fellow travelers for now, the rising stock market and inverted yield curve cannot coexist forever.
(Caroline Baum, author of ``Just What I Said,'' is a columnist for Bloomberg News. The opinions expressed are her own.) |
