On Friday, the bond market once again flashed what has historically been a reliable sign of an imminent US recession – a reversed US government bond yield curve – after trade tensions with China heated up, triggering a 2.6% sale in it broader stock market. This indicator has been happening several times since Wednesday, August 14, when it led the market and resulted in the S&P 500 index falling nearly 3%.
The reverse yield curve was initially heard before the economic downturn in March, but last week marked the first time since the end of 2005 that there was an inversion of what is considered the main portion of the yield curve.
If this leading reverse economic indicator still has its good predictive mojo, the stock market is roaring, the decade-long beef market may be coming to an end. Here's what you should know.
What is a reverse interest rate curve?
A reverse yield curve occurs when interest rates on bonds with longer maturities are lower than for bonds with shorter maturities. It arises because investors are anxious about the economic climate and donate money in bonds over the long term, which they regard as safe havens. As money flows in, the prices of these bonds go up – in a typical supply / demand way – while yields go down.
It is worth noting two things: Some economists believe that the reverse yield curve does not have the same predictive power as it once had, and there may be considerable time between this phenomenon and the start of a recession. The time between a reverse yield curve and the official start of a recession has varied from several months to about two years.
I think it is more likely than not that a recession is on its way, as it seems wise to bet on an economic indicator that has such a good track record (which we will get to in a moment). The timing is likely to depend on several factors, including the Federal Reserve's future interest rate measures and how things play out with the Trump administration's trade war with China.
Recent Reverse Yield Curves
14. August, the yield on the benchmark 10-year US Treasury portfolio dipped short below the yield on the 2-year note, resulting in an inversion of the bulk of the yield curve. However, the yield curve came later in the day. This scenario has played out several times since then, with Friday being the last.
Instead of looking at yield curves, it is easier to imagine things using a diagram that shows the spread between the yields of the two banknotes. And it's also easier to visualize things if you focus on August 14 and August 22. During at least one point on each of these days, the spread line in the following chart fell below 0.00% (the horizontal or x-axis), which means that the 10-year note yielded slightly less than the 2-year note. In all cases since last week and through this time (mid-afternoon Friday), the yield curve returned to its normal form at the end of the trading day, which is why none of the spread lines in this chart show as below 0.00%.
How good is the inverted yield curve to predict recessions?
In the table below, you can see that the yield curve between the 10-year and two-year Treasuries was reversed before each of the five recessions (indicated in gray band) over the past four decades. (This is as far back as YCharts data goes.) The inversion occurs when the line on the graph drops below 0.00%. (The label is not visible, but it is the horizontal line just below "0.01%", which is the return on August 22 between these two annotations.)
But what about false alarms or reverse return curves appearing on the scene without recession after? When it goes as far back as the 1960s, there has only been one false positive – it happened in the mid-60s. So the reverse yield curve is not the boy like gray wolf.
Homing in on the Great Recession
The following chart allows us to see more clearly when the inversions of the 10-2 Treasury yield curve happened that preceded the start of the Great Recession, the longest US recession since World War II and World War II the deepest since the Great Depression, which began in 1929 and ended with the start of World War II. The major recession technically lasted from December 2007 to June 2009, but many of its negative effects persisted for many years after the official end. The 10-2 Treasury interest spread's first dip below 0.00% came in late December 2005, but the alarm bells went really crazy from about mid-2006 to early 2008 – or started about 1-1 / 2 years from when the recession officially began.
Of course, this is not to say that this pattern has been the same for every recession or will be the same for the next major economic downturn. But I think the saying that applies here is that although the story does not repeat, it often rhymes (original source disputed).
The broader stock market was plunged during the recession. In the 18 months that the Great Recession gripped the nation and the world, the S&P 500 index (including dividends) fell by as much as 36%. Also, it took years for the various stock indices and many stocks to climb back to previous levels.
Not all stocks fell during the recession – and in fact some did quite well. The following chart includes 10 stocks and one exchange-traded fund (ETF) that gained during this adverse economic period. These investments should not be considered recommended purchases, and this list is not all inclusive – it is simply meant to show that there are winners during recession and to illustrate which stocks tend to hold up or even thrive when the economy mind. Perhaps not surprisingly, half of the shares are dividend payers.
The question that comes to mind here is, how have these stocks performed since the start of the recession?
All recessions have surpassed the market since the start of the Great Recession, except for generic medicine manufacturer Teva Pharmaceutical and ETF, iShares Gold Trust . (We'll get to all the shares in a moment.) There is certainly some self-selection going on here: Companies whose shares performed well in the recession were probably generally more difficult than many other companies that went into it. So we expect that at least many of them will continue their performance during the economic upswing, too.
And here is a sample of eight stocks that were quite resilient during the recession, and suffered only one-digit losses. They are all exploiters, except for Bridgford Foods .
And how have these stocks performed from the start of the recent recession until now?
Interestingly, all of the eight stocks outperformed the market since the downturn. We come to these shares below.
Types of stocks that tend to stick around in tough economic times
Companies that sell small fees ("lipstick stocks")
In difficult economic times, it is natural that people will often put off buying big ticket items . But – and this may seem counter-intuitive – many people will actually increase spending at reasonable small fees, according to some research. The reasoning is that they want to avoid being deprived, and reward themselves for having made a greater sacrifice. This phenomenon is called Lipstick Effect. The term was coined at the beginning of the 2000s by Leonard Lauder, then chairman of Estee Lauder who found that in tough economic climates, the company's sales of cosmetics increased.
Since then, some studies have suggested that we should kiss off lipstick sales as a reverse indicator of financial health, but there is research that supports the general theory. In other words, Lipstick Effect could use a new first name.
Several of the stocks in the recession winner lists can be considered "lipstick stocks": fast food leader McDonald's (NYSE: MCD) ; National Beverage which is best known for its sparkling water from LaCroix, but also makes soft drinks, juices and energy drinks; and J&J Snack Foods which produces niche foods and frozen drinks, including soft pretzels from Superpretzel and frozen Icee drinks. Video Steam Pioneer and Leader Netflix (NASDAQ: NFLX) has been a massive winner because it disrupted a few huge industries – including movie chains and cable TV companies – but it also fits into the lipstick stock category.
In terms of dividends, McDonald's and J&J Snack shares are up 2.1% and 1.1%, respectively, from August 22. National Beverage and Netflix do not pay dividends.
The two charts that show the shares than remained relatively steady during the recession include chocolate maker Hershey and leading toy manufacturer Hasbro may also fall into the lipstick stock classification. Both shares pay dividends, with Hershey's return of 2% and Hasbro's 2.4%.
Most consumers in developed countries will not cut down on daily water use in even the most challenging economic conditions, making water supplies a good choice to be in a recession. Three water supply stocks – Connecticut Water California Water Service and York Water – are in the inventory of stocks that remained relatively steady during the recession. There are many solid dividend-paying stocks in this group, but American Water Works (NYSE: AWK) is, in my opinion, the best in the class in the long run. The New Jersey-based company's industry-leading size and geographical diversity give it a head start in the acquisition area, which is an important advantage since the US water industry is quite fragmented. The dividend yield is 1.6% as of August 22.
American Water went public in late April 2008, so it was not traded in the first five months of the Great Recession. That said, the stock lost nearly 13% of its value during that part of the recession when it traded, and has returned a whopping 724% since its original IPO, more than four times the S&P 500's 168% return. Of course, past performance does not guarantee future performance, but good long-term performance often indicates that a company has a solid competitive advantage.
Other types of tools
While electrical and gas-efficient tools generally hold up well during economic downturns, they are generally not as recession-resistant as water supplies. Consumers are more likely to scale back on the goods these tools provide, than to call back water consumption. While electric power plant NextEra Energy (NYSE: NEE) did not make the lists (the stock fell almost 16% during the recession), it is a top choice to juice up long-term returns. Along with owning two power companies in their home base in Florida, it is the world's largest generator of renewable energy from wind and solar. The dividend of the NextEra stock is currently 2.3%. The stock has returned 361% since the start of the recent recession, more than twice the return on the broader market.
Even in poor economic environments, people tend to still eat meals, wash their hair, clean houses and so on. Two consumer booklet stocks in the downturn for charts are Poultry Producer Sanderson Farms and Lancaster Colony who make specialty food products for the retail and food service markets.
There are a few consumer leaflets in the lists of stocks that remained relatively stable during the Great Recession. Manufacturer of home and personal care Church & Dwight (NYSE: CHD) makes a good investment choice in this category. The 170-year-old company has done a great job of utilizing the iconic and ultra-versatile baking powder Arm and Hammer for a wide range of value-added products. In the same lists is Bridgford Foods, which grinds out foods such as frozen bread dough and beef, and Flowers Foods a large producer of baked goods. Dough is not the only thing rising at Flowers, as it has solid results in raising the dividend, which currently yields 3.3% – the richest dividend on the shares discussed in this August 22 article.  Beyond Flowers, dividend yield: Sanderson 0.9%, Lancaster Colony 1.7% and Church & Dwight 1.2%. Again, Bridgford does not pay a dividend.
Health Care Companies
In general, the stocks of generic drug manufacturers remained relatively healthy during the Great Recession. This makes sense, since some consumers are likely to replace generic prescription drugs when they feel anxious about their financial well-being. Shares of Teva (in the fall chart's winning tables) and Allergan (not in the lists) both rose in single digits during the recession. The Teva share – which does not pay dividends – has since plunged, while Allergan – which gives 1.8% – has returned 475% since the recession to August 22, roughly tripling the broader market return.
When consumers feel uncertain or inferior about the economy, they tend to be more price conscious. During the Great Recession, this was the world's largest retailer, Walmart (NYSE: WMT) focusing on low prices, and Dollar Tree specializing in very low-priced goods. Shares of Walmart returned more than 7% during the 18 months of the recession, while the Dollar Tree stock apparently grew money on trees, with a gain of 56%. Both stocks have also outperformed the market since the downturn. I am not fond of any of them: Amazon has eaten Walmart's lunch in the e-commerce area, which is constantly growing, and Dollar Tree does not have a solid moat to keep competitors in check. Walmart's dividend yields 1.9%. Dollar Tree does not pay dividends.
Companies with products that allow people to postpone major purchases
Auto parts retailer O & # 39; Reilly Automotive (in the recession's winning tables) fall into this category. O & # 39; Reilly does not pay dividends.
Gold and silver
In times of economic uncertainty, many investors flock to gold and silver, which are seen as safe havens. These precious metals are also regarded as inflation hedges. Not surprisingly, iShares Gold Trust was a big winner – jumping around 24% – during the recent recession, while the same company's Silver Trust (not shown) also rose. Both funds have underperformed the market significantly since the downturn. This is also not surprising, as investment in precious metal usually does not light up when the economy is buzzing and consumer confidence is high. In general, this place is best left to short-term traders, in my opinion. These are not "put-and-forget" stocks.
What about "sin stores"?
Conventional wisdom has what so-called sin stores – such as those containing tobacco, alcoholic beverages and games – tend to do relatively well when the economy goes south. I did not find this to be true during the great downturn. My site check of the shares of the top companies in these three areas showed that most of them struggled during the recession.
Now is a good time to review your stock portfolio
Now is a good time to review your portfolio and consider switching to a more defensive stance. This generally means favoring the dividend-paying shares of stable companies whose products and services are in demand regardless of the economic climate. Two of my favorite dividend payments that fit the bill are American Water and NextEra Energy. That said, shares in the "lipstick stocks" and consumer staples categories are worth exploring further, especially Netflix, Church & Dwight and J&J Snack Foods.
Although you think a recession is in the short term radar, it is generally not a good idea to get completely out of the stock market or sell all your growth rates. If you do, you risk missing the often explosive early stages of the next big leg, as market timing is notoriously difficult.