Thompson’s Note: The world’s most feared—and accurate—recession indicator just sent a warning.

Maybe you’ve seen the headlines…

“The bond market is flashing a warning sign a recession may be coming. Here’s why”—CNBC

The indicator we’re talking about is the inverted yield curve. It’s predicted almost every recession over the past 50+ years.

Smart Money Monday readers know I don’t focus on macro events—I’m a bottoms-up stock picker. But I still follow macro developments, and the yield curve is an indicator I’m always monitoring.

Today I’m passing along an important essay from Stephen McBride, a longtime friend of Mauldin Economics and chief analyst at RiskHedge. He’ll break down everything you need to know about this recession indicator in plain English. And more important, he’ll show you how to think about it so you can make rational investment decisions.

I think you’ll come away from this essay more confident about staying in the market and continuing to take advantage of the smart stock picks we cover in Smart Money Monday.

Feel free to pass this essay along. And if you have any questions for me or Stephen, I encourage you to join us at SIC 2022, May 2‒13. We’ll both be available for Q&A on the final day of the event. Get more details here.

* * *

There’s a lot of fear in the markets right now.

Inflation…

The war in Ukraine…

Rising interest rates…

And now the “inverted yield curve.”

• What the heck is an inverted yield curve… and why does it matter to you?

If you’ve applied for a mortgage, you know the two most popular options are a 15-year mortgage or a 30-year mortgage.

The interest rate you’ll pay on a 15-year mortgage is lower than what you’d pay on a 30-year one.

Which makes sense, right? With the 30-year mortgage, you’re borrowing the bank’s money for twice as long. So you must pay a higher rate.

It’s the same with the interest rates the US government pays on its bonds. 99.9% of the time, the longer out a bond goes, the higher rate it pays. A 10-year bond almost always pays higher interest than a 2-year bond.

Last month, the interest rate on the 10-year US bond sank below the interest rate on a 2-year bond.

This “upside-down” situation is what investors call an inverted yield curve.

• And it’s typically a reliable sign that something is “off” with the US economy...

It’s rare for the yield curve to invert. It’s only happened 8 times since 1969.

It last happened in September 2019. The COVID-19 recession followed seven months later.

The time before that, it happened in January 2006. Roughly two years later, we entered the 2008 financial crisis. US stocks cratered 57% in 08–09.

More bad news: Every time the yield curve has inverted in the last 50 years, a recession has eventually followed.

Recessions are bad for stocks. From 1920–2019, US stocks sank into a “bear market” 10 times. Eight of the 10 have come inside a recession­.

• This sounds pretty bad, Stephen…

But here’s the #1 detail about the inverted yield curve most investors don’t hear about…

The yield curve inversion typically warns of a recession over a year in advance. From the time the yield curve first inverts, a recession hits about 18 months later, on average.

Eighteen months is a long time. In 18 months, we’ll be talking about the next presidential election. Your kids will be two grades older.

And in the 18 months after the yield curve inverts, stocks usually perform well... and sometimes they perform GREAT.

The last time the yield curve inverted in 2019, the S&P 500 gained 19% before the COVID crash.

When it happened in 2006, the S&P 500 crept up 22% before the onset of the financial crisis.

And the time before that, in 1998, stocks soared 55% before peaking. And the Nasdaq jumped 210% to form the infamous dot-com bubble.

Not only is there a long lag between this signal flashing red and stocks topping out—you could say a yield curve inversion is a BUY signal for stocks, at least in the short and medium term.

• Here’s what I’m doing with my money right now.

Many investors assume they only have two choices now that the yield curve has inverted:

Sell all their stocks and park the cash in their bank accounts…

Or hang on and hope the next recession doesn’t wipe them out.

This “all or nothing” mentality is a rookie mistake.

There is a better way.

Don’t panic. PREPARE.

Prepare by committing to disciplined risk management with each stock you own. Any investor can do this by using “stops.”

As you may know, a “stop” is a predetermined price at which you’ll sell a stock. Say you buy a stock at $100 and put a 20% stop on it. If the stock falls to $80, you sell immediately. No questions asked, and no second guessing the decision.

Used correctly, stops keep any losses small while allowing your winners to ride.

That way, if US markets continue to perform well for one year... two years... three years... or more... your nest egg will keep growing.

And if markets turn down tomorrow, your stops act like a “circuit breaker” for your portfolio. They’ll get you out before a stock loses too much ground.

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  Let me be clear: The yield curve inversion is a “red flag” to take seriously.

It’s one of the most reliable indicators of a recession there is. It’s definitely not a good thing. It would be irresponsible to ignore it.

But as I said, 18 months is a long time. The average person has about 35 working years, or 420 months, to build wealth through investing.

Eighteen months represents more than 4% of your investing life.

Are you willing to squander 4% of your investing life?

To park your money on the sidelines until a potential recession comes and goes?

With scary headlines swirling, that might “feel” like the safe, prudent thing to do.

But the data is clear. For the next 18 months or so, the yield curve suggests we’re in an environment where it has historically been good or great to own stocks.

Think carefully before you waste it.

* * *

Thompson Clark here again…

We have an impressive roster of 50+ speakers and panelists lined up for the SIC this year. As excited as I am to hear from world-class thinkers like Carlyle Group co-founder David M. Rubenstein and Baron Funds CEO Ron Baron, I might be even more excited to connect with my readers on SIC PLUS day on May 13. Because this event is ultimately about you—our readers—and making sure you have the most thoughtful, timely research and analysis to guide your financial decisions. If you haven’t secured your spot at this exclusive virtual event yet, go here.

—Thompson Clark
Editor, Smart Money Monday

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