The yield curve–stock market showdown

  • S&P 500 is poised to close out one of its strongest Q1s since 1951
  • Recent yield-curve inversion renewed recession debate
  • Strong Q1s have typically translated into up years

The stock market, as the old saying goes, climbs a wall a worry. No matter how relentless the uptrend, there’s never a shortage of voices warning that the latest earnings miss or weak economic number (regardless of whether it appears to be an aberration) is evidence of a crack in the dike that will soon unleash a bearish flood.

SPX 500 (SPX), 12/31/19–3/27/19. SPX 500 (SPX). Q1 on the run.

Source: Power E*TRADE

The fault line du jour is last Friday’s yield-curve inversion (long-term interest rates dropped below short-term interest rates), which came a couple of days after the Fed scaled back its 2019-2020 economic forecast for the US, and as the S&P 500 (SPX) was closing in on a record Q1 (chart above). To make a long, boring economic story short:

  1. Yield-curve inversions (in this case, the 10-year US Treasury rate falling below the three-month rate) imply less confidence in the longer-term economic outlook, and have been fairly accurate predictors of past recessions.1
  2. Recessions aren’t generally good for the stock market.

Although even if such inversions were perfect indicators of future recessions, they don’t tell you little things like, oh, when one will start (other than "in the next 12 months"), how deep it will be, or the degree to which the stock market will respond. That said, stocks apparently took note of last Friday’s inversion, with the SPX falling 1.9% amid “Bond market warns of recession” headlines.

If the S&P 500 closes at 2,758 or higher on March 29, it will be only the 11th time since 1951 that it’s gained 10% or more in Q1.

It’s also possible that investor jitters were amplified by the stock market’s red-hot start to 2019. Since the inversion occurred a day after the SPX enjoyed one of its biggest up days of the year and expanded its Q1 gain to nearly 14%, there may have been an element of, “Woah, maybe we’ve gotten a little ahead of ourselves.”

But with all the talk about what the bond market is “saying,” no one seems to be paying much attention to the stock market’s opinion on the matter. When the closing bell rings tomorrow, there’s a good chance the S&P 500 (SPX) will notch one of its best first quarters of the past 68 years: If it closes at 2,758 or higher it will post a 10% or larger Q1 return, something it’s done only 10 other times since 1951, most recently in 2013.

So, what do big Q1s potentially “say” about the market’s future? Take a look at the following table, which compares the SPX’s April performance after 10% or larger Q1s to its performance in all other Aprils:

SPX April performance, 1951–2018

Source: Power E*TRADE

After big Q1s, the SPX’s median April return was only 0.2%, and it closed the month higher six of 10 times (60%)—positive, but worse than the numbers for all other Aprils. So, traders who think the market is due to cool off a bit after a big run would appear to have some ammunition for their argument. Adjust strategies accordingly—perhaps take profits more quickly on long trades, work short-side opportunities when available, etc.

But April is just one month. Now look at a breakdown of what the SPX did for the remainder of the year after big Q1s:

SPX April-December performance, 1951–2018.

Source: Power E*TRADE

While the SPX’s typical April–December return after big Q1s is only slightly larger than it is after all other Q1s, the index gained ground 90% of the time. So, based on the available data, this year’s sizable Q1 rally wouldn’t seem to imply any unusual weakness for the remainder of the year. Of course, there’s always the chance this could be the year that deviates from the norm—get ready for someone to point out that 1987 had the second-strongest Q1 of the past seven decades, even if the evidence suggests that’s not the typical outcome.

The words “the bond market is warning of recession” have probably gobbled up a significant portion of internet bandwidth recently—in fact, yesterday “recession” hit its highest level of popularity as a Google search term since December 22, which happened to be two days before the US stock market’s current bottom.2  

Experienced traders know to listen to different areas of the market, and to put what they hear in context.

Today’s numbers (all times ET): GDP (8:30 a.m.), Corporate Profits (8:30 a.m.), Pending Home Sales Index (10 a.m.).

Today’s earnings include: Accenture (ACN), SMART Global (SGH).


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1 The New York Times. Stocks Fall as Bond Market Flashes a Recession Warning. 3/22/19.

2 Google Trends. “Recession” search term. 3/27/19.

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