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Yield Curve Doesn't Spell Doom
By James Altucher
RealMoney.com Contributor
12/28/2005 11:32 AM EST

Everyone was agitated Tuesday about the yield curve. Heck, I was.

The yield curve has been threatening inversion for months. When it actually happens, how can financial institutions make money? They can't borrow short to lend long anymore.

However, an inversion doesn't necessarily mean that stock markets will fall.

I took a look at all of the times since World War II when the 10-year yield was lower than the two-year, and then where the S&P 500 was one year later.

Yields inverted 16 times, and the S&P 500 was up one year later only six times. However, the average return was positive -- 0.15% -- and over the past 30 years the results haven't been bad at all (though there have only been a few occurrences).

Of the seven occurrences since 1975, stocks were higher one year later four times, with an average return of 5.47%. Note that this last result is not statistically significant because the number of occurrences is too small.

Yield Inversion and the S&P 500
When the 10-year yield has lower than the two-year, the S&P 500 has fallen most of the time
Entry Date Entry Price Exit Date Exit Price % Change
5/1/1956 45.2 5/1/1957 47.43 4.93
9/1/1959 56.88 9/1/1960 53.52 -5.91
1/3/1966 92.88 1/3/1967 86.61 -6.75
3/1/1967 90.2 3/1/1968 90.2 0
6/3/1968 99.58 6/2/1969 97.71 -1.88
7/1/1969 91.83 7/1/1970 78.05 -15.01
11/2/1970 87.2 11/1/1971 93.99 7.79
3/1/1973 111.52 3/1/1974 93.98 -15.73
4/1/1974 90.31 4/1/1975 87.3 -3.33
10/1/1975 89.04 10/1/1976 102.9 15.57
8/1/1978 103.29 8/1/1979 109.32 5.84
9/2/1980 125.46 9/1/1981 116.18 -7.4
1/4/1982 120.4 1/3/1983 145.3 20.68
8/1/1989 351.45 8/1/1990 322.56 -8.22
6/1/1998 1,133.84 6/1/1999 1,372.71 21.07
2/1/2000 1,366.42 2/1/2001 1,239.94 -9.26
Source: Formula Capita

How many of these inversions resulted in recessions?

All of the business cycles since 1854 are listed on the National Bureau of Economic Research's Web site.

If you look at them, it's hard to see a cause-and-effect relationship with inversions. The inversion of May 1956 may be linked to the recession of August 1957. Or maybe not. At least a few of the inversions (for instance, June 1998 and January 1966) are nowhere near recessions, so there can be no guilt by association.

Clearly, an inversion is not the best thing that can happen. Financial institutions like to borrow short so they can lend long. The flip side is that when consumers get loans in an inverted environment, the interest rates are usually not onerous and any inflation that occurs in the system becomes beneficial to them, particularly if long-term rates get locked in. The inversion of mid-1998, combined with the liquidity Greenspan pumped into the markets after the Long Term Credit Management affair, was enough to create a short-term bubble that fueled all asset prices for the next two years.

So to sum up, could a recession occur? Maybe, but its unclear it's really linked to the inversion. Could a bear market occur? Possibly, but in the past 30 years that's not what has happened on average.

Some pundits are saying the 10-year can't go lower. But in the inversions of 1956 and 1959, the 10-year yield was lower than it is now. So who knows?

My view is to completely ignore it and continue to find good stocks with great balance sheets, because that means their financing options are wide open and they won't be dependent on any covenants.

http://www.thestreet.com/p/_htmlrmd/rmoney/marketcommentary/10259265.html