I’m feeling conflicted. Should I stick with the old way of interpreting data or submit to a new interpretation?
This always happens. The data gives us one signal that has always proven reliable. However, many people don’t like the answer, so they reinterpret the data to mean what they want.
For macro investors, every time the yield curve inverts, it forecasts a recession is around the corner. (An inverted yield curve occurs when 3-month government bonds yield more than 10-year bonds.)
People never like to hear a recession is imminent. Instead, they want the good news to keep coming.
But the yield curve inverted in May of 2019. Less than a year later, we were in a recession.
Back in May 2019, there was a lot of speculation that the signal wouldn’t work this time. People said interest rates were so low, they were distorting the data and were not reliable.
I remember a similar argument in 2006. No one believed a recession was about to unfold. They were wrong.
You might say the yield-curve signal was just lucky this time. No one could have predicted the pandemic back in May 2019.
The problem with that conclusion is the yield-curve spread has predicted almost every recession for more than 60 years. There is always a shock that is difficult if not impossible to predict.
The lesson from the yield curve is that when liquidity is tight and interest rates have been rising, the economy can’t deal with shocks as well. That’s why the yield curve is such a good indicator.
I was thinking a lot about this over the weekend because of the upcoming election.
When the stock market rallies in the month ahead of an election, it usually signals the incumbent is going to win. By this analysis, the stock market has predicted every outcome since 1980 and is 87% accurate since 1928.
The Nasdaq-100 and the S&P 500 are in the region of their all-time peaks following impressive rallies over the last few weeks. If we go with the historical record, that suggests President Trump will be reelected.
However, that’s not at all what many journalists are concluding. Instead, they believe the stock market strength is a response to the possibility the Democratic Party will win a landslide victory.
Their rationale is the margin of a Democratic victory will be so large, there will be no possibility of a contested result.
That may be the case, but there’s an easier explanation. Perhaps the market is rallying because investors believe corporate taxes will not rise if President Trump is reelected.
It may also be rallying because investors believe Congress is going to pass a big new stimulus sooner or later, regardless of who wins.
A rising stock market has tended to support the incumbent because markets don’t like change. When the going is good, why rock the boat? That’s the rationale investors live by.
The other thing I find unsettling is the assumption of a double-digit election victory. When sports team supporters celebrate the victory before the game even starts, it’s usually a sign of hubris. I’m all for enthusiasm, but the winner of an election depends on how many electoral college votes you win. Coastal elites patting each other on the back for a job well done does not win elections.
Systematic and quantitative trading have been working in the stock market for years. The time to doubt the data is when it stops working. Not before.
If the stock market continues to rally over the next month, the election is going to be a lot tighter than many journalists would like to believe is possible. It would mean the balance of probabilities is President Trump will be reelected.
All the best,