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A Yield Curve Inversion Signals Recession
On Dec. 22, 1997, the 10-2 year treasury yield spread dipped to nearly zero, sending academics into a panic. The “bond inversion” indicator has predicted every recession since the 1950s.
But few investors noticed.
Instead, tech startups like Amazon (NASDAQ:AMZN) would continue partying like college kids at a frat party. Shares of the e-commerce startup would rise 189% over the following 6 months. Capital One (NYSE:COF), a bellwether of retail spending, likewise saw its stock advance 116% over the same period.
Though the tech bubble would eventually end in a massive correction, it turns out that inverted yield curves generally warn about recessions far too early.
Don’t believe me?
Consider the next time the spread hit near-zero in December 2005. The top performers over the following 6 months were energy and agricultural stocks, continuing their winning streak over Chinese demand:
- BP Prudhoe Bay Trust (NYSE:BPT). +289%
- Enservco Corp (NYSEAMERICAN:ENSV). +194%
- Marine Petroleum Trust (NASDAQ:MARPS). +176%
- LSB Industries (NYSE:LXU). +176%
The ensuing inversion in August 2019? Biotechs were the big winners:
- ChemoCentryx (NASDAQ:CCXI). 605%
- Kodiak Sciences (NASDAQ:KOD). 480%
- Applied Therapeutics (NASDAQ:APLT). 418%
- Immunitybio (NASDAQ:IBRX). +392%
In each of these cases, inverted yield curves were like the investor who cried “bear market!” Warn about a nonexistent recession for long enough, and people eventually begin to ignore you like a professor trying to teach a Finance 101 class during a March Madness game.
Even corporate bigwigs like AMC Entertainment (NYSE:AMC) CEO Adam Aron are ignoring the signs. On Monday, the 67-year-old said the movie theater firm would pursue more “transformational” deals in addition to its purchase of a gold mine penny stock. Its shares have almost doubled in the past week.
There’s no doubt that lower-quality picks will eventually become bear fodder (imagine your Finance professor saying, “I told you so”). ChemoCentryx and Kodiak Sciences saw their shares lose 85% after their meteoric 2019 rise. And firms like AMC will eventually have to contend with their lack of cash flow. Historically, no bull market has survived longer than 3 years after a bond inversion.
But not every hot stock is doomed to fail. Amazon would eventually prevail despite the dot-com crash, and Capital One continues to out-earn its peer banks.
Today, we’re going to take a look at one group of Moonshots that will perform today, in an overheating economy, and tomorrow, during the eventual bear market fallout: green energy stocks.
The Green Energy Revolution Is Here. High-Quality Will Win.
Past bond inversions generally spark bull runs in the “hot stocks” of the day.
Tech… Energy… Biotech…
So what’s the right industry to buy now?
It’s one riding a wave of retail investor interest today with enough secular tailwinds to outlast the eventual pullback: fossil fuel alternatives.
Top Quality Moonshot Pick: Cameco (CCJ)
Canada’s top uranium miner should come as no surprise selection to regular Moonshot readers. The company sits on three of the world’s most productive mines, giving it an unbeatable cost advantage.
Now Cameco (NYSE:CCJ) has another reason to celebrate: the shift away from Russian energy.
Russian and Kazakh firms produced almost half of all exported uranium in 2021. With sanctions expanding by the day, traders are scrambling to find alternative sources of fuel.
Cameco’s Saskatchewan-based mines fit the bill.
The rise of small modular reactors (SMRs) is also renewing interest in safer nuclear power. A design pioneered by Oregon-based NuScale stands just 65 feet tall with the width of an SUV. These smaller plants allow for faster construction and provide an essential backup for when the wind doesn’t blow or the sun doesn’t shine.
There are also significant safety benefits to SMRs. Smaller reactors typically house only one-twentieth of the nuclear fuel of a typical 1,000MW reactor, making them safer to manage and far less dangerous in the event of a failure.
While commercial use of SMRs could remain years off, the rise in energy nationalism has propelled this Moonshot technology to the forefront. So while oil prices might fall again, don’t expect nuclear to disappear so quickly.
Speculative Pick: Vestas Wind Systems (VWDRY)
Meanwhile, the race for European energy independence is propelling that continent’s largest wind turbine maker back to the forefront.
Danish-based Vestas (OTCMKTS:VWDRY) has seen stiff competition since 2017. Returns on fixed assets plummeted from over 40% in 2016 to 4% on a sagging order book and rising costs. MW installed dropped 19% in 2021.
Russia’s invasion of Ukraine changes the calculus entirely. Germany now plans on reaching 100% renewable energy by 2035, nearly two decades ahead of schedule. Even Poland, a traditionally coal-consuming country, announced plans in early March to cut approval times for wind projects by two-thirds. They now hope to double the share of renewables by 2040.
This is… well… a windfall for Vestas. Not only does the firm benefit as new capacity is installed, but its service business will also gain as more of its turbines are put to work. It’s a virtuous cycle where today’s sales lead to greater future profits.
With governments worldwide rethinking their renewables strategy, Vestas looks set to return a 40% to 50% gain.
More Green Energy Picks
My colleague Luke Lango hasn’t been sitting still either. In his latest presentation, he talks about a $3 stock that’s powering the next generation of electric vehicles.
It’s a company that people need to know. Renewables like wind and solar are creating an arms race in energy storage technologies, and it’s still a game that anyone can win.
To see the video, please click here.
When Will a Crash Happen?
Inverted yield curves don’t necessarily cause recessions.
“We find that a monetary policy easing, reflected in either a lower current real-interest rate level or a decline in the expected real-rate spread, is associated with an increase in the probability of a recession within the next year,” explain researchers at the Chicago Federal Reserve. In other words, inverted yield curves are only an indication of a recession’s root cause: overly loose monetary policy.
It’s the same force that created our current markets. High asset prices… inflation… rampant speculation… and a growing sense that the party will never end.
It’s also why the timing of recessions is so hard to predict. Much like relying on your dog’s behavior to predict earthquakes, using yield curves to forecast recessions is akin to relying on tangential evidence.
Yet there are some clues.
The first is trading volume, a sign of market depth. Trading volumes are already slowing for million-dollar NFTs — a warning that the tokenization market is reaching saturation. Meanwhile, triple-leveraged ETFs continue to see record inflows, suggesting that stocks still have room to run.
The second is the Fed, the ultimate wet blanket at a stock market party. In October, I noted how Fed Chair Jerome Powell was turning hawkish faster than most investors realized; the S&P 500 and Nasdaq would fall into a bear market not long after. Now that Mr. Powell has reversed course, it’s a sign he’s willing to let inflation run higher in exchange for delaying a recession.
Finally, we have real estate prices, a proxy for investor confidence. With home prices and rents continuing to accelerate, homeowners are still feeling wealthier. A sudden reversal would spell trouble.
Together, these three signals are still pointing to blue skies ahead. But once clouds start rolling in, make sure you have an umbrella. It’ll be a big storm ahead.
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On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.