So far this year, investing in the S&P 500 index would have achieved an abysmal return of 2.26 percent. So there is no surprise that there is no shortage of pundits calling for a market crash in 2015 like this one. Since it is almost half way through 2015, it is worth reexamining such claim. Should we worry about it?
First, it is worth establishing what we mean by a bear market. It is common to say that the market is a bear one if it has fallen from the previous high by at least 20 percent. Note that this is a rough definition, but generally a good guide, and by this definition, an investor wouldn’t have panicked during the 10-percent market correction during October last year. In fact, it offered a good entry point for trading, and you would have gain 16.95 percent return on your investment in seven months! Of course, most of us have a 20-20 hindsight vision.
I should note that I use the S&P 500 index as a substitute for the US economy. This is not entirely correct, but it is a good approximation. In fact, it is a leading indicator for the economy, since the market is usually more reactive to news than official monthly data (It requires two consecutive quarters of negative GDP growth for the economy to be considered in recession).
An economy during a boom is like a well-oiled engine. We can think of an economy as the sum of all transactions that occur in that economic region and it is the banking sector that provides liquidity for transactions to occur with ease like lubricant oil. So, when there is a shortage of liquidity (money), generally it is the first sign that the economy is in trouble. In a nutshell, the state of the banking sector gives us a pretty good idea of what is likely to occur in the near future.
There is a saying: banks buy short, sell long. What this means is that: A bank will give you interest on your deposit or take short-term loans from other banks, which are equivalent to buying short-term debts. On the other hand, it lends out long-term loans at higher interest rates, like mortgages, long-term bonds or corporate loans.
During any normal economic period, the short-term interest rates are generally less than the long-term interest rates. One of the reasons is that most investors like quick access to cash and therefore they have to pay higher premium for a short-term investment in term of reduced return on investment. With this in mind, when we see that when the long-term interest rates are equal or below the short-term interest rates, this reduces banks ability to make profit. This generally leads to a shortage of money and potentially a recession.
The chart above shows the yields of 10-year US treasury bond (long-term rates) minus the Federal Reserve cash rates (short-term rates) since 1954. The shade areas indicate recessions in the US. As we can observe, prior to every recession the long-term interest rates were either close to or less than the short-term interest rates as indicated by the graph dropping close to or below zero. Here, I should point out that when the graph is negative, it does not mean that we are going to have a recession. It is just highly likely.
From the chart, we can also see that from a historical perspective, the current difference between the two rates is indicative of economic expansion period. However, this does not mean that there will be no market crash in 2015. It is just highly unlikely.
Disclaimer: The information presented on this blog represents my own opinion. I do not give any specific recommendation on any investment. Please conduct due diligence before investing.