March 31, 2022

There’s been a lot of talk lately about a potential yield curve inversion (happened briefly on Tuesday), so I did some work earlier in the week to see what the data says about small- and large-cap stock performance around inversions.

The bottom line is that since 1956 both large caps and small caps have tended to struggle when the yield curve inverts.

But in more recent history (six examples since 1978) there are plenty of times both asset classes posted positive returns. And throughout history, after emerging from inversions, both have tended to do well, with small-cap stocks doing extremely well.

I have the data to share. But first just a quick reminder on what a yield curve inversion is and why it matters.

A yield curve inversion occurs when short-dated Treasuries pay higher yields than longer-dated bonds. Most market observers focus on the gap between two- and 10-year yields.

An inverted yield curve – when the two-year yields more than the 10-year – is not a great sign. Under normal circumstances investors want more yield if they are to tie up capital for longer. This helps compensate for the risk of inflation, rate hikes, etc.

When the yield curve inverts that logic goes out the window.

Yield curve inversions have proven to be one of the best predictors of a coming recession, preceding 10 out of the last 13 such scenarios. That said, timing is not precise (i.e., it’s not like yield curve inverts and recession hits the next quarter).

This relationship is clearly seen in the following chart from the St. Louis Fed. Note how recessions (shaded areas) tended to follow when the spread between the two-year and 10-year went negative.

As of this morning the spread is 0.04%. This follows a very brief inversion Tuesday that lasted just a few minutes. With the yield curve right on the cusp of another inversion, this relationship will likely be top of mind for a while. Hence my interest in what the data says.

Now on to that, which I have sourced from Bank of America Global Research.

As you can see in the last 11 inversions (dating back to 1956) large caps have fallen by an average of 5.7% between the time when the yield curve inverted and when it came out of inversion.

In the last 11 inversions small caps have fallen by an average of 6.8% between the time when the yield curve inverted and when it came out of inversion.

That said, both large and small caps were positive in four of the last six inversion periods and posted an average gain of 2.9% over the most recent six examples.

What about coming out of inversion?

The data shows both large- and small-cap stocks tend to do very well coming out of inversions. Over the last 11 inversion exits, large caps were up by an average of 16.2% by the time the yield curve peaked.

Small caps were up by an average of 29.3%, almost twice as much as large caps.

What are the caveats?

There are different circumstances each time the yield curve inverts, including how long it takes to exit inversion. It’s one thing if stocks are down for 10 months, as happened in 2000. But it’s another thing if they’re down for almost three years, as was the case in 1967-70.

At a high level, influencing factors include GDP, unemployment, interest rates and macro environment in the period leading up to, and subsequent to, a yield curve inversion.

As we all know, this time around interest rates are very low and inflation is very high. So, the Fed doesn’t have any room to slash rates should the economy start to slow down too much.

However, the Fed’s balance sheet is at a record high (see the 10-year chart below) of nearly $9 trillion. The importance of this can’t be overstated as the Fed’s balance sheet strategy will have an impact on interest rates, and thus the yield curve, as we move deeper into 2022.

In other words, it’s not just about Fed interest rate policy. The balance sheet matters too.

Should the Fed take steps to reduce the size of its balance sheet, interest rates should go up as liquidity is pulled out of the financial system. This could also help rein in inflation as there would be less money chasing goods.

Stepping back, there is (unfortunately) no single predictor of what will happen in the market should the yield curve invert again. There are just too many influencing factors.

Based on the evidence in front of us right now, I don’t love that the yield curve just inverted, but it’s not keeping me up at night (plenty of other things do!). I’m more concerned with how investors will react as we get deeper into the Fed rate hike cycle if rates keep shooting higher but inflation doesn’t ease.

I’m also interested in what could happen if the Fed is able to engineer a “soft landing” and the yield curve trends away from this recent “technical” inversion, or we see another short-duration inversion. The data coming out of inversions is very encouraging almost every single time (but again, duration matters).

Enough about that. On to our stocks.

Recent Changes
None

Updates
Arena Pharmaceuticals (ARNA) was sold (second half position) on Tuesday March 8 prior to the acquisition by Pfizer (PFE). SOLD

Avalara (AVLR) is up modestly over the last week. I’m maintaining at hold as I’d like to see AVLR hold the 100 level. Management announced some new low-code developer tools to help with integrations. This stock “should” do well in 2022. Recall guidance was ahead of consensus on revenue while profit margins will get pinched due to another investment wave. That might not be exciting to investors now but should be for those that can look out a few quarters. HOLD

CS DISCO (LAW) has continued to move higher for the second week (up roughly 7%) and is now modestly above its 50-day moving average line. This is another “give up some margin to go after growth” story (like AVLR) and these haven’t been all that well received by investors. But again, we have to look out in time a little. CS Disco is a young, disruptive software company with a legal cloud platform that is gaining scale. It’s not going to continue to do so if the business is put on cruise control because investors have stepped back from software stocks. BUY

Inspire Medical Systems (INSP) has tacked on around 9% over the last week as shares jumped above the 250 level for the first time since January 5. There’s no news but I continue to see a lot of signs of investor interest in MedTech names. HOLD

Procept Biorobotics (PRCT) is roughly flat since last Wednesday’s close, which is fine by me. Shares are up nearly 40% since we added the position less than a month ago and a little consolidation might be a good thing. Recall management issued 2021 revenue guidance of $54 - $58 million (up 57% - 68%), well ahead of consensus estimates for $50 million. Lockup expiration passed on 3/14. BUY

JOANN (JOAN) was sold following Q4 results which showed that new customers aren’t spending as much as expected. I think there are better opportunities elsewhere. SOLD

Nova LTD (NVMI) came up off its lows near 100 two weeks ago and has moved sideways over the last five sessions. The takeaways from the Q4 report were that the company is effectively managing through a difficult supply chain environment and has upside to growth if things improve on that front. Nova has roughly $450 million in cash and is buying back shares even while on track to deliver EPS over $5.00 per share by 2023. Bigger picture, investor conviction in semi stocks has taken a hit (SOX down roughly twice as much as S&P 500 YTD) on concerns of peak demand and slower consumer spending on devices and computers. But the big, big picture of more complex everything (autos, datacenters, etc.) is bullish for semi. Acknowledging this is a boom-bust type sector we’ll keep potential headwinds to a capital equipment player like Nova in mind but continue to lean bullish for now as it feels like the semi bull market could continue. BUY

Rani Therapeutics (RANI) gave a Q4 update on Tuesday, and I listened to the conference call. There wasn’t anything too huge announced, though there were some interesting tidbits on the call. As we already knew, Rani started a Phase 1 study of RT-102 (parathyroid hormone in RaniPill for osteoporosis) in Australia to study pharmacokinetics, safety and tolerability in healthy adult women. The company should release topline data for this in the second half of this year, when it expects to start another Phase 1 study. The other big news is the RaniPill High Capacity (HC), which will allow delivery of therapeutic payloads up to 500% larger than the original RaniPill. Yet this pill is the same size, about the size of a fish oil capsule, so it won’t be harder for patients to swallow. Management said there will be some additional testing on the device required before final approval and that the market potential is considerable given the therapies that can be delivered. Rani says it has cash on hand to fund development through 2023. That said, should they want to accelerate any programs, add new ones, or strike any joint ventures they may need to tap the market for cash sooner. I expect we would see an equity raise later this year if RANI shares can move materially higher (guessing back in the 25-35 range) and Phase 1 results are good. Big picture, things are still on track here for a very early-stage opportunity. BUY

Revolve (RVLV) has put together two weeks of solid progress and, prior to yesterday’s pullback, was within 10% of the February high (64). We’ve seen some movement with certain retailers lately (LULU’s three day rally this week was particularly eye opening) indicating that investors have begun to snap up some of these beaten down names. I suspect RVLV’s upside may be capped in the near term as investors will be curious to see what consumer spending trends are like in Q1 and heading into spring/summer (the Q1 earnings call should provide some insight into this). Of note, RVLV generates roughly 15% of revenue from Europe so there is some exposure there if European consumers reign in spending (not a major concern at the moment for RVLV specifically). HOLD

Repligen (RGEN) continues to be OK but not great as it bounces around in the (mostly) 170 – 205 range. Sticking with a hold rating. HOLD

Shutterstock (SSTK) popped to a two-and-a-half-month high Tuesday as the stock’s upward trend is beginning to take shape. No major news. Shutterstock operates a marketplace for licensed digital imagery for sale to media and marketing agencies. BUY

Sprout Social (SPT) had another constructive week as the stock was able to hold on to gains from the previous two weeks and is comfortably back above its 50-day moving average and trading near 81.5. We now set our sights on the next level of overhead resistance (97 – 100 zone, about where the 200-DMA is). Not moving back to buy until we see more follow through across the software space. HOLD HALF

Xometry (XMTR) has been a bit of a head scratcher lately as I had expected the stock to react very well to the Q4 report from two Thursdays ago. Revenue was +77% to $67.1 million, beating by $1.86 million, and EPS of -$0.29 was in line. Full-year 2022 revenue guide is $390 - $400 million (+83% at the high end), also above consensus of $381 million. Despite the results and outlook, XMTR fell back to previous lows below 34. That said, the stock has been “stable” since and could well be setting up for a move higher. It’s a relative newcomer and probably not a stock many investors know about (market cap just $1.6 billion). That may well mean it’s just further down the potential buy list of software names, which haven’t been in huge demand lately. Being mindful that the stock trend here is not strong but the story is, we’ll keep at buy a bit longer. Xometry was just approved to expand the breadth of medical device manufacturing on its marketplace. BUY

Please email me at tyler@cabotwealth.com with any questions or comments about any of our stocks, or anything else on your mind.