Best & Worst Real Historical Returns: Where To Invest?

With the first stock market correction in over a year, having occurred in early February, there were many media narratives about what caused the selloff. We think it was driven by the unwind of the short VIX trade. Buying protection wasn’t considered important with the VIX at record lows in 2017. However, when nobody thinks there’s a need for protection, it’s probably a good idea to buy some especially since it’s cheap. Shorting the VIX is shorting protection. The stock market was like a car driving 80 miles per hour where the riders were betting against the need for airbags. The tail wagged the dog as the derivatives market moved stocks instead of the reverse.

For some reason, the 10-year bond yield got blamed for the selloff even though it had been increasing for months beforehand while stocks rallied. Furthermore, when the selling occurred, yields actually fell and then they rose after the correction ended. Some analysis implies the 10-year bond yield needs to hit 3.5% to affect stocks and other analysis shows stocks rally with every 100 basis point movement higher in bond yields. The chart below supports the latter point.

Factor Performance During Corrections

The chart above shows past examples of corrections in the stock market, broken down between when bond yields (BY) rose and when they fell. When yields fell, defensive stocks outperformed and when bond yields rose it was more mixed. This suggests that bond yields are correlated to economic growth. When growth expectations are falling, defensive stocks outperform, which isn’t necessarily great because the overall market is usually underperforming or declining.

Inflation Curve Flattening

The yield curve is the best cycle timing measurement. While it’s tough for metrics to remain consistent in a rapidly changing world, the yield curve has remained accurate in this business cycle. By remaining normal, the yield curve has correctly suggested the expansion will continue. The numerous corrections in the flattening trend have prevented an inversion. Many investment banks are calling for a recession sometime between 2019 and 2021 because, if the trend continues, it looks like an inversion will occur in the next 12 months. They assume the flattening will continue and that the recession will occur about 1-2 years after the inversion. It’s a possibility, but far from certainty.

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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