#34 S2N: Spreading it thin

Author

micksonmatch
April 04, 2024

In today’s issue:

  • Spreading it thin (spotlight)

  • Shiller PE overvalued

Today’s Spotlight

Spreading it thin

I am going to need to build up to my main point, as many might be unfamiliar with some of these concepts. Let me start with the US bond yield curve.

If you look at the months on the x-axis, you will see months. This represents the duration of the bond. So 120 months represents the 10-year bond. You can see on the vertical axis the yield each bond duration is earning. The shape of the curve is not normal, as usually the further out in time, the higher the interest rates should be. The above chart has one extra wrinkle in it. I plot the curve for today, last week, and a month ago. This helps you get a feel for how the shape of the curve is changing over time.

Let us zone in on the classic yield spread between the 10yr minus the 2yr. History shows that every single time the spread inverts, i.e. below zero, there is a recession. You will recognise the periods when it turns red, as they are associated with recessions.

I have only ever read about an inverted yield curve (negative spread) and its forecasting ability for recessions. However, I have never seen how a negative spread acts as a signal for investing in the SP500 until I did the analysis today.

I applied a very simple rule: I bought the SP500 when the spread was positive and sold it when it was negative. The cumulative return for a buy-and-hold strategy is better than trading the negative spread. However, if you were paying attention yesterday, you will recall that I said one should always be focused on risk-adjusted returns. This is where we rely on Nobel Laurette William Sharpe’s Sharpe Ratio (S.R.) which helps us compare apples with pears.

Despite the fact that the negative spread strategy has missed the post-COVID rally, it has a S.R of 0.57 versus a 0.56 buy-and-hold. The fact that the market has behaved so differently for this negative spread (inversion) has been extremely surprising. The market is still inverted. I will keep you posted when the spread turns positive.

S2N Insights

Shiller PE overvalued

As for the U.S. market in general, there has never been a sustained rally starting from a 34 Shiller P/E. The only bull markets that continued up from levels like this were the last 18 months in Japan until 1989, and the U.S. tech bubble of 1998 and 1999, and we know how those ended.

Jeremy Grantham is one of the great value investors who wrote last week.

As you can see, the orange line in the chart above is representative of the Shiller PE ratio which is currently sitting at 34, which is more than 2 standard deviations above its 140-year mean. We are in an expensive zone.

In the regression below, I compare the future 10-year returns versus the current Shiller PE ratio. You can see that where we are now at 34 is rare territory, and just like Grantham says, it has never been associated with a sustained rally. I stand by my earlier call of taking half my exposure to the SP500 off.

Performance Review

To learn a bit more about the Z-Score, which I use for the colour signals, read this blog post.

Chart Gallery

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