Further thoughts on yield curve inversion

Some value investors become almost evangelic about their need NOT to utilize economic inputs in their thinking. I apologize if I offend you, but since I believe that most companies do have some economic sensitivity, particularly smaller companies, I do find it useful to spend a bit of time in economic thinking. Though signs of excess seem to be present primarily in housing and real estate markets, and less so in other capital markets, one should always be somewhat defensive in at least considering the downside risk in your portfolio.

Some further thoughts on yield curve inversion from “The Big Picture.”

“Growth of less than 1% in real M2 in the past four quarters, combined with a sharp contraction in total bank reserves, reinforces what the yield curve is telling us: The economy is headed for a slowdown. That means either less inflation, less real growth, or some combination of the two."

See also: WSJ (Subscription required)

An academic dissertation by Paul Francis Cwik at Auburn University addresses at some length the reasons why the yield curve inverts prior to recessions.

Quoting from his excellent dissertation:

“The analysis then shows that short-term credit can create both short- and long-term malinvestments in the social structure of production. The restricted model demonstrates that, during the malinvestment boom phase, both short- and long-term malinvestments emerge in the early stages of production. These malinvestments are unsustainable and must be liquidated.
The crunch phase of the business cycle begins this process of liquidation. This phase may take the form of a credit crunch, a real resource crunch, or a combination of the two. Each scenario culminates in an inverted yield curve approximately one year before the upper-turning point of a recession. Each recession since the mid-1950s is categorized and is placed into either the credit crunch or the real resource crunch scenarios.”

Despite some comments that I have read regarding the nature of the “new economy” and its lower reliance on inventories, I do not believe that recessions are an artefact of history. The cleansing of excesses that occurs with recession is never pleasant and unfortunately is cyclic and repetitive just as the development of excesses.

As value investors, this signal reminds us to pay attention to balance sheets, to bank and debt covenants, and to operating cash flows. It suggests that is a great time to temper and modulate the risk in your portfolio.

Buy quality when it is there, not when it has a chance of happening!