“I’m A Believer” – The Monkees Weren’t The Only Big Hit Of 1966-67

Coming into 2022, there were few investors advocating for a bear market. (We were very cautious. See here: A Return To Regular Order? (forbes.com)). Consensus then was that the Fed would soon rein in ‘transitory’ inflation, earnings would stay strong even if they reverted from euphoric estimates, and that bond yields would ease off their rise from the covid bottom. Camp Consensus pitched their tents in the wrong spot as 2022 was a brutal year for equity and fixed income markets. For 2023 the consensus has switched about 180 degrees as it seems that almost unanimously investors and pundits are calling for an imminent recession. There has never been as many professional forecasters calling for recession as there are now. So, what could the bull case be?

No doubt, everyone knows that there is an inverted yield curve today. An inverted yield curve occurs when multiple shorter dated maturities sit at higher yields than longer dated maturities. Conventional market wisdom says that an inverted yield curve has predicted every recession in the United States, going back to the 1950’s. This we find to be correct, every single recession has been led, by varying degrees of time, by inversions of the government bond yield curve. Let’s ask a different question: has an inverted yield curve always led to a recession? the answer is no, by a N of 1, in 1966.

In 1966, while everyone was busy listening to the Monkees and watching “The Sound of Music”, the Federal Reserve was fighting inflation. This rise in inflation was accompanied by several years of strong real GDP growth, low unemployment, and Federal government spending on both military and social programs. In response to the spike in inflation, the Federal Reserve began an aggressive tightening campaign. According to Bloomberg data, the Federal Funds rate went from 3.5% in 1964 to 5.75% in 1966, thus inverting the yield curve. Concurrently, the S&P 500 Total Return Index fell -16% to a low in Q3 1966.

What followed was that rare economic bird sighting- the elusive “soft landing”. In 1967, real GDP fell to a low of 0.3%, but never contracted on a quarterly SAAR basis. Industrial production year-over-year fell to -0.18% but never contracted on a quarterly basis. Unemployment fell slightly to 3.8%. Corporate profits contracted by about -7.5% from the previous year. The Fed cut interest rates all the way into the summer of 1967 by about 2%. The S&P 500 had a wonderful bull run from Oct 1966 thru Oct 1967 of about 30% (dividends included).

Contrasting the 1960s with today there are clear differences in both situation and magnitude, but there are also striking similarities. First, the 10-Year Treasury is inverted below all other maturities. Second, we had a meteoric rise in CPI after years of stable prices. Interest rates had been stable and low for years, resulting in large amounts of Federal spending. Nominal economic activity remains high, and the labor market remains tight. As of Q3, household net worth measured by the Fed’s FlowFLOW2
of Funds, has only contracted -1.4%, and household checking account balances have increased to $5.12 trillion dollars from $4.062 trillion a year earlier, leaving the capacity for strong spending.

Nominally speaking, the economy today is still in a strong spot, very similar to 1966. It is possible that once again, the inverted yield curve might be premature in calling the recession. That said, there are still clear headwinds to the market and economy today that can’t be ignored. First, monetary policy is a headwind to asset returns and economic activity. There was a pivot in 1966, but today any talk of pivot or pause is still speculation. Second, leading indicators are all pointing to contraction levels. Third, despite the bear market, equities remain expensive on a long-term basis and are still widely held by households and institutions. Putting it all together, it is possible that the real recession is further off than people think and that contrarian investors should be cautiously open to allocating to pockets of value or oversold quality companies.

I wish we could be as confident as songwriter Neil Diamond (yes, he penned the Monkees’ mega hit) who was a believer- “Not a trace of doubt in my mind”. Alas, like most things in asset allocation we manage for risk. In this case consider the risk that 2023, already panned as recessionary, looks like 1966-67. At a minimum, it may be time to cover some equity hedges.

All data for this column was sourced from Bloomberg LP.