It's been quite a time for the markets this August.
First the Reserve Bank cut the Official Cash Rate to a new record low of 1 per cent and last week we observed the first inversion of the US yield curve between two-year bonds and 10-year bonds since 2007 – which means the returns from short-term bonds were higher than from long-term bonds (usually, it's the other way around, because investors demand higher returns for waiting longer until they get their money).
This has drummed up a lot of noise because many investors and industry people see an inverted yield curve as a sign that a recession is one or two years away.
But many experts argue that today's economy is different enough from that of the past. Plus, there's more attention to the yield curve nowadays, which could cause investors to react more in response.
So, we can't rely on the yield curve as a sure indicator. (Again: Nobody out there has a crystal ball.)
Historically, yield curves have mostly been upwardly sloping (short-term rates lower than long-term rates), but there have also been several periods when the yield curve has either been flat or inverted.
Marlena Lee, co-head of research at Dimensional, an asset manager that oversees $905 billion said, "We didn't see much reliable evidence that yield-curve inversions were indications you should get out of equities. About 70 per cent of them were followed by positive equity returns. Much better than a coin toss."
While the handful of instances of curve inversions in the US may concern investors, the small number of US yield curve inversions over the last 40 years makes it challenging to draw a strong connection and evidence from around the world suggests investors should not extrapolate from the US experience.
Dimensional looked at stock performance in the aftermath of 15 yield-curve inversions in Australia, Germany, Japan, the UK and U.S. dating back to 1985.
According to a Dimensional research report in August, looking at the broader group of nations, equities had positive returns 86 per cent of the time 12 months after an inversion and 71 per cent of the time after 36 months.
These results show that it is difficult to predict the timing and direction of equity market moves following a yield curve inversion.
Though the data set is limited, an analysis of yield curve inversions in five major developed countries shows that an inversion may not be a reliable indicator of stock market downturns.
The takeaway here is that the stock market doesn't go straight up.
In fact, historically speaking, stocks have had a roughly 53 per cent chance of rising and a 47 per cent chance of falling on any given day. People may think they should wait for a pullback to invest, but the data shows that historically, "time in the market beats timing the market."
So, what can investors do if they are concerned about potential equity weakness?
Investors may be better able to look past short-term noise and focus on investing in a systematic way that will help meet long-term goals by developing and sticking to a long-term plan that is in line with their risk tolerance.
And more importantly, partnering with a financial adviser who will not adjust, and trade clients' portfolios based upon the optimism and expectations of successful US-China trade negotiations (very topical) – and then pessimism when talks break down!
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