The Inverted Yield Curve and Stock Performance - Free Essay Example

The choice of stocks to invest in during a period of recession has gained importance once again since the global meltdown in 2008. Ideally individuals and fund managers should be able to predict a forthcoming recession and there should be some method of identifying stocks that do better in such periods. In USA, inverted yield curves have been used to predict downturns and some studies have shown that returns from large capitalization stocks are significantly higher than small stocks, during the time of recession. A yield curve shows the relationship between interest rates and maturities of the debt instruments issued by the same issuer. Long-term interest rates are normally higher than short-term rates, making the yield curve upward sloping.When long-term interest rates are lower than short-term rates, the yield curve is downward sloping, i.e. inverted. Yield curve inversion indicates that long term investors are grim about the future prospects of the economy and thus, are willing to settle for lower long term yields.An inverted yield curve normally signals a recession, which begins about six months later. The stock market usually begins to fall six months prior to any recession. So, the appearance of an inverted yield curve normally is followed very shortly by a falling stock market. Fact: The inverted yield curve is an anomaly, happens rarely, and is almost always followed by a recession. Historically, inversions of the yield curve have precededÂÂ  many of theÂÂ  U.S. recessions. Due to this historical correlation, the yield curveÂÂ  is often seen as anÂÂ  accurate forecast of the turning points of the business cycle. The yield curve inversion was noticed in the USA each time before the 1981, 1991, 2000 and the recent 2008 economic downfalls. Within four to six quarters of the yield curve inversion, the economy witnessed the recession. Some investors may believe that big cap stocks are preferred over mid or small cap stocks when the yield curve is inverted. This belief could be based on the expectation that an inverted yield curve precedes an economic slowdown, i.e., a recession. They may perceive that larger firms tend to be better able to weather economic downturns than smaller firms. The perception may be based on the assumptions that, in general, larger firms: 1) Have better access to capital 2) Can reduce their costs more easily 3) Are more diversified than smaller firms If such an effect can be proved to exist in the context of Indian markets, then it would prove to be an immense help for all classes of stock market investors. As in this case, as soon as an inversion in the yield curve is noticed it would act as an indicator to channelise funds towards big cap stocks and avail of the opportunity of buying these stocks low and enjoying an increased Holding Period Yield in the post inversion period. In a study conducted in the USA on an average, small and mid cap stocks outperformed big cap stocks before the yield curve inversion; big cap stocks outperformed both small and mid cap stocks during the period of inverted yield curve. In particular, the biggest cap stocks performed best with the only statistical significance when the yield curve was inverted. Of course, the outstanding performance could be due to factors other than the inverted yield curve. However, it is a reasonable assessment that the in verted yield curve contributed to the positive performance of the biggest SP 500 group in particular. This is probably because investors would have sought for a safe haven alternative during the period of inverted yield curve. They probably considered the biggest cap stocks as the best alternative during the inverted yield curve. But when the same study was replicated in Indian context it gave entirely different results. This may be because the yield curve inversion in India occurred as an after effect of economic downfall. Each time the USA economy plunged into an economic downfall, it was preceded by a yield curve inversion whether it was before the Great Depression or the crisis in 1981, 1991, 2000 or the recent 2007 downfall. The reason why yield curve send such strong signals in the USA is also because of the developed and the well traded bond market there. But in case of India yield curve has not been able to establish itself as such a strong indicator of recession. W hile in the USA yield curve inverts at least four quarters before the recession, in case of India its more of a reactionary thing. The yield curve in India inverted after the spillover effect of US downturn had already reached India. The stock market after running a boom rally in 2007, started falling sharply mid January 2008 onwards, while the yield curve inversion in India was noticed on 10th -11th Sept. 2008. This is unlike USA where the yield curve inverts at least six months prior to the stock market fall. A reason for this can also be the underdeveloped status of our bond market, where predominantly institutional players like banks and insurance companies are active that too because they have to comply with the respective regulations applicable to them for holding a minimum balance in government bonds. Thus there is no active trading in the bond market in India as the aim of these players is not profit making. Thus in India inversion occurs as an after effect of economic downfall, it cannot have been used as a predictor of recession. Also after the inversion occurred the stocks irrespective of their market capitalization performed better. The returns during the period of inverted yield curve were statistically significant for all of the smallest, biggest and the middle cap stocks. Thus it can be concluded that here in India, there is no specific big firm affect associated with the inverted yield curve. Though one conclusion that can be reached to is that in Indias case whether it is recession or no recession, it is the big cap stocks that give a higher return as compared to the mid and small cap stocks. By Nishtha Anand