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Yield Curves...


...can be subjectively validating.

Apropos of the yield curve inversion thread this morning, I thought I'd share a few historical observations as well. All four of the last full yield curve inversions (defined as a yield curve inversion greater than negative 5 basis points) have resulted, on average, in an S&P 500 decline of 14.8% one year following inversion (-13% in 2001, -6.6% in 1990, -9.7% in 1981, and -29.7% in 1974).

So how does this square with Tony's observations that the SPX gained 13% inside of 6 months on the 'last four inversions?' It doesn't. Here's why:

Everything I just did above - citing the average decline after the last four 'full' inversions - is epistemologically flawed.

It's called data mining.

By tightly defining the parameters of the inversion ("full inversion greater than negative 5 basis points") and the parameters of the 'look back' ("one year following inversion"), and by providing the average performance (-14.8%) instead of the median performance (-11.4%), I am performing two common errors. The first is selection bias, which is the error of distorting a statistical analysis by pre- or post-selecting the data to fit a pre-formed (conscious or unconscious) conclusion. The second is subjective validation, in which people accept a conclusion as true a priori based on a small sample set of experiences and/or an existing subjective perception.

Selection bias helps to explain why there are so many satisfied customers who go to psychics, tarot card readers, palmists, etc. Because the customers are highly motivated to be helped and to have the psychic/card reader/healer 'succeed,' they inevitably (and entirely unconsciously) believe they have indeed succeeded.

One of the reasons we have cited the Federal Reserve study that concluded that yield curve inversions have 'predicted' every subsequent recession save for one since 1950 is that it does not (ostensibly) suffer from the same reasoning errors as what I (and Tony) did above. Further, nowhere have I, in past comments about yield curve inversions, suggested stock prices should do this or that. Instead, we have opted to speak to what the yield curve action tells us about time preferences of those investors acting in the market for capital (the bond market). Because we have other models/indicators that provide a probability-weighted assessment of future stock price action, we merely look to market-based indicators like yield curves to tell us how global risk preferences are changing.

We cannot - NOT - infer that those risk preference changes alone will lead to specific negative performance in, say, stocks. All we can do is look at the environment in which those changed risk preferences are operating: John spoke directly to this idea when he mentioned the real interest rate level with this inversion as well as the absolute debt levels (as % of GDP, etc.) that exist right now. Those are specific and important qualitative differences between ALL other yield curve inversions and the potential present one (as long as it gets below -5 bps).

And, just as we cannot predict negative performance based on changing risk preferences, we certainly cannot predict positive performance either. By citing the specific period between 1982 and present, Tony has chosen the single best period of stock performance in the history of man. During that time, the compound annual return of the SPX was 21.3% versus the long run average of just under 9%: several standard deviations from mean. As we have stated in the past, one could choose almost ANY statistic in this period - skirt lengths, P/Es, interest rate differentials - and come up with a conclusion that such a condition always leads to higher stocks prices, because it did: from 1982 to now. But that it did makes the conclusion now and going forward no more valid (post hoc ergo prompter hoc strikes again).

The subject of bias - of how we as investors fool ourselves - is endlessly fascinating because of the physiological, mental and emotional causes of those biases. Fascinating if you are aware of their existence. Potentially dangerous if you are not.
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