There's a group of stocks that’s helped investors survive the worst crashes since the 1920s — and it looks like the perfect hedge for an inverted yield curve

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There's a group of stocks that's helped investors survive the worst crashes since the 1920s — and it looks like the perfect hedge for an inverted yield curve

The inversion of a portion of the yield curve late last week reignited fears of a US economic recession.
If the infamous Treasury-market signal is positive this time, stocks will be vulnerable to losses.
Societe Generale has identified a group of stocks that's fared better than the broader market during downturns since the 1920s — one it says is poised to be an effective hedge against another market crash.

In the realm of recession indicators, the yield curve's track record is hard to beat.

Long-term Treasury yields have fallen below their short-term counterparts before every US recession since 1955. It's an abnormal occurrence because bond traders, worried about imminent risks, demand a higher compensation for buying short-term bonds versus locking up their money for nearly a decade.

On Friday, the 10-year yield, which had already been at its lowest level in a year, fell below the 3-month yield for the first time since 2007. This naturally set off alarm bells about an economic slowdown that sucks the air out of the stock market's rally.

There's usually a lag between yield-curve inversions and recessions, meaning investors are now stuck with the uncertainty over whether this notorious signal will be positive this time.

For Andrew Lapthorne, the head of quantitative equity research at Societe Generale, the inversion isn't of much practical use yet.

However, what it immediately confirmed to him was that the Federal Reserve's about-turn on interest rates was squarely because of its concerns about economic weakness.

"Given the already mediocre outlook for corporate profit growth in 2019, and that EPS momentum was already fading fast, the outlook is looking increasingly ominous," Lapthorne said in a note to clients.

That dim outlook helps to explain the vicious sell-off that immediately followed the yield-curve inversion on Friday.

Among the casualties were value stocks, a cohort that investors favor for their solid fundamentals and relative cheapness based on metrics like their price-to-earnings ratios.

According to Lapthorne, value stocks are poised to be an effective hedge against an economic slowdown that pushes down bond yields as their prices rise.

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He held his bullish view on value long before Wall Street's worries about the yield curve and recession flared up.

When the big growth stocks in the tech sector faltered last year, Lapthorne said the value strategy was poised for a resurgence after years of underperformance.

This chart illustrates why. It shows the US Fama-French Value factor during 25 periods of market turmoil dating back to the 1920s. While value was not immune to broader sell-offs in the S&P 500, it fared better. On average, value fell 2.4% per episode versus 25% for the S&P 500.

Now that concerns about an economic slowdown are more palpable, he is reiterating value as a hideout from a possible meltdown in the stock market.

"We have been arguing that value was attractive as a hedge against rising bond yields, and of course bond yields have been going down not up, but we have also been arguing that value stocks are 'cheap' — a view that hasn't changed despite the many obvious fundamental risks attached to them," Lapthorne said.

He continued: "We think this 'cheapness' might reduce downside risks in an economic slowdown and more importantly spell greater upside if, just as in 2016, policy makers change tack." Read »