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Will the Canadian Yield Curve Inversion Make Mincemeat of Your Stocks?

Overvaluation in the markets may be a concern against the backdrop of a yield curve inversion, something which has been occupying the attention of U.S. economics pundits in recent months, though not so much domestic ones. And yes, just as the U.S. yield curve inversion signals recession, so might a Canadian one.

American investment managers BlackRock have signaled the alarm over projected tightening of bank lending in this country over a flattening Canadian yield curve. While the Canadian inversion is historically less accurate than the American one in predicting recession, 10 out of 15 Canadian yield curve inversions since 1961 have preceded an economic contraction in the ensuing year.

What sorts of stocks are at risk?

Overvalued stocks are likely to fare badly from a Canadian yield curve inversion. Stocks like our FAANG-alike tech favourites, nicknamed the DOCKS, may come in for a bashing. Take Descartes Systems (TSX:DSG)(NYSE:DSGX) for instance.

Overvalued by about half its future cash flow value, Descartes Systems is not what you might call a value investor’s dream stock. It’s a favourite for tech investors and a good alternative to the usual round of American FAANGs, and that should tell you a bit about what to expect from its valuation. Indeed, a P/E ratio of over 99 times earnings is probably all you need to know, though if you need to look further, it’s also trading at over five times its book value.

One of the main reasons why stocks like this are such a risk is that their forecast high growth is dependent on the stability of the current economic system. A recession could make mincemeat of Descartes Systems’s 23.6% expected annual growth in earnings, making that PEG ratio of 4.2 times growth even less palatable.

It’s sometimes said that when things get really dicey to stay away from banks, but for the TSX index, banking is a traditional provider of stability and security. Consider some of the more solid players, though do keep an eye of discount banking stocks that do well in their own provinces.

So, what happens next?

If the Federal Reserve doesn’t catch the signal in the U.S. or reads it inappropriately, it’s possible that overconfidence could once again be the undoing of the U.S. economy. And while bullishness continues to predominate in not only the American markets but also the TSX index, an overtightening of fiscal behaviour on either side of the border could flip that country’s respective yield curve.

What’s interesting, from a socio-economic perspective, is that the bottom line for the Fed looks to be the U.S. unemployment rate — and the problem at the moment is that it’s technically too low. The Fed’s objective appears to be to increase unemployment by purposefully slowing growth in order to head off inflation. It would be interesting to see how fiscal maneuvering in Canada might offset our own potential downturn.

The bottom line

Could a recession be on the way? Bullishness in the financial sector suggests no. And yet some worrying factors are present: volatile oil prices, rising interest rates, consumer jitters, a softening real estate market, an overheating of the economy, and a backdrop of protectionist tariffs. All of these weigh on the markets, and a bad decision by U.S. or Canadian financial regulators could pull the trigger on a widespread downturn.

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Fool contributor Victoria Hetherington has no position in any of the stocks mentioned.

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