I’m pretty sure kids were different when I was young.

I recall being respectful and inquisitive. I would ask questions and appreciate the answers adults gave me. But now, from the age of about four onwards, kids today think they know everything.

I asked my mom, and she is certain I am wrong. When she finally stopped laughing at me, she said that while I was also a precocious four-year old, I am respectful and inquisitive now.

As I read through some research reports this weekend, I was left with the feeling that some analysts are more like know-it-all four-year olds. Some seem unwilling to look past the current situation, even when there is information readily available to help them understand the historical context.

Here’s what I mean…

Last week’s big news story is that the yield curve is no longer inverted. This is causing some analysts to change their opinions, even some who just weeks ago proclaimed the recession was near because the yield curve inverted.

On CNBC, the story is that “bond yields are surging, and the scary recession warning everyone was talking about has gone away.” At Forbes, we are told, “Recession Via Inverted Yield Curve? Gone, So Focus On Stocks.”

For these analysts, the yield curve doesn’t require any understanding of history or context. It’s either inverted (bad) or not inverted (good).

The good news for me is that I know a four-year old who would be good at this type of analysis. He’s never wrong and never looks past the moment he is experiencing. I was worried about him, but now I see that even if he never changes, he will find his place in the world providing half-baked analysis for journalists with deadlines.

Instead of responding to this indicator like a preschooler, let’s take a respectful and inquisitive look at it.

What’s Really Going On With The Yield Curve

First, let’s find the historical context of the yield curve. The chart below shows the difference between the yield on 10-year Treasury notes and three-month T-bills. Normally, interest rates for 10-year loans are higher than for three-month loans, so the value of the difference is greater than zero (the thick black horizontal line in the chart). Values less than zero mean the yield curve is inverted.

In this case, it’s especially important to consider the yield curve’s history.

That history, based on all available historical data in the Federal Reserve online database, shows that recessions occur only after the yield curve has returned to normal.

This tells me that the yield curve is actually warning us that we are closer to the recession than ever.

One thing that’s interesting to me about the yield curve indicator is that it was discovered less than 35 years ago. The first reference to the importance of the yield curve is in Dr. Harvey Campbell’s 1986 Ph.D. dissertation, “Recovering Expectations of Consumption Growth From an Equilibrium Model of the Term Structure of Interest Rates.”

The chart above shows all the post-publication occurrences of the inverted yield curve. There were just three signals and there were no false signals. This is impressive for an indicator like this.

The New York Times asked Campbell to comment on the current state of the market and he noted, “In a way, the damage is done. If you look at the track record, if you’ve got an inversion, there is a recession that follows.”

But Campbell noted that this time is different — the Fed is already cutting interest rates. That’s a big change compared to the Fed’s response to the inversion we saw in 2006. Back then, they waited a year before beginning to lower short-term rates.

“In the face of the inversion, [the Fed] did nothing,” Mr. Harvey said. “This inversion, they actually did cut.”

What This Means

So, does this mean we’ve avoided a recession?

Not exactly. While some analysts have already started sounding the “all clear,” I believe the Fed’s actions have simply delayed the coming recession. As we learned from looking at this indicator’s history, recessions always follow inversions, and they occur only after the yield curve has returned to normal. At most, I think the Fed’s decision to cut rates will only delay what history has shown to be inevitable. In the past, recessions occurred within two years of the yield curve inversion; assuming a delayed timeline, we may not see the recession until 2021.

This is good news for stocks. There could be significant gains as the market rallies into the beginning of the recession, which is something we have seen in the past.

That’s a longer-term outlook. In the short run, I believe we should see a pullback in the S&P 500. The chart below shows the index with the Profit Amplifier Momentum (PAM) index. PAM is weakening and looks likely to turn down in the next week. (Note: While there is the possibility that the indicator will quickly reverse, PAM was designed to avoid these kind of whipsaws — so this is unlikely.)

If we do see a pullback, I believe it will be short-lived. As always, I will be monitoring the market closely and update you next week.

I will keep an open mind in my analysis and follow the indicators rather than choosing an opinion and sticking with it even as the evidence mounts against me. I believe being inquisitive and open-minded are good traits in an analyst. They are also good traits in 4-year olds. I’m working on that, but that’s another story.

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