This Is the Inversion Stock Investors Should Sweat

U.S. stock investors who are anxiously watching the yield curve are worried about the wrong inversion.  

Investors have been howling about interest rates since Monday, when part of the U.S. Treasury yield curve inverted for the first time since 2007. The five-year Treasury yield dipped below that of the three year by a razor-thin 0.01 percentage points. Yawn.

Granted, that’s not supposed to happen. The yields for longer-term bonds should be higher than those for shorter-term ones to compensate bond investors for parting with their money for a longer period. When investors accept a lower yield for longer-term bonds, it implies that they expect interest rates to decline. And declining rates have often been accompanied by recessions and bear markets.

But the fuss is overdone, at least so far. The “inversion” is so minuscule that it’s imperceptible on an actual yield curve. It’s also limited to a small part of the curve. As others have already pointed out, an inversion between the two-year and 10-year Treasury yields would be more noteworthy. 

Instead, investors should keep an eye on a different inversion: the difference between the earnings yield on stocks and the yield on cash. When the earnings yield has dipped below the cash yield in the past, stocks were in for a rough ride.

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Investors Are Supposed to Be Rewarded for Risk, Right?

After the Federal Reserve raised the federal funds rate as expected on Wednesday, investors are no doubt watching how longer-term interest rates respond. But the stock market’s moves will be just as revealing.  

U.S. stocks have been on a historic run since the 2008 financial crisis. The S&P 500 Index has returned 18 percent annually from March 2009 through August, including dividends, making it one of the best decades for stocks since 1926. It’s also the second-longest stretch without a bear market, as defined by a decline of 20 percent or more.

Bulls attribute much of that success to lower interest rates. It’s no coincidence that stocks skyrocketed soon after the Fed dropped rates in late 2008 in response to the financial crisis, they argue, and that the market kept moving higher while the Fed held rates low for years.  

The gist of the argument is that investors expect a premium for owning risky stocks rather than safe bonds — in technical jargon, an equity risk premium. When bond yields decline, stocks can pay less, too, provided that the premium stays roughly the same. But there’s little evidence investors are paying attention to the premium.

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