Where Are We NOW?
Chart: Jill Mislinski/Doug Short at Advisor Perspectives.
This linear scale chart of the S&P 500 with the 50- and 200-day moving averages overlaid traces the path of the first bull market in Wall Street History to last an entire decade (10 years) according to InvesTech Research.
The Fed’s abrupt change in interest rate policy set the stage for a spectacular first quarter rally which began on Christmas eve 2018. At the beginning of May, the S&P not only recovered the losses from last year’s frightening sell-off it briefly surpassed 2018 record highs before finally running out of steam.
Based on improving market fundamentals and the resilience in market breadth and leadership during the first quarter there is no denying the possibility that this bull market may have enough gas in the tank for another leg up in 2019. With economic reports remaining positive and consumer confidence near a 20-year high, it’s tempting for investors to surrender to the early year euphoria and to go “all in.”
Late-stage bull markets require a different investing strategy than early-stage markets. For all the bobbing around in a sea of fearsome volatility during the past 16 months, the S&P 500 is currently sitting at about the same point it was at the end of 2017.
Consumer spending accounts for two-thirds of GDP in the U.S. Thus, consumers’ confidence in the current economic situation is critical to their spending habits and the continued health of this expansion. Historically, as the economy strengthens, the feeling of well-being carries over to the shopping public and confidence surveys always reach their highest levels late in a mature bull market.
Chart Source: Jill Mislinski/Doug Short at Advisor Perspectives
The Consumer Confidence “Present Situation” Index (above at 134.1) has rarely been higher. Only the euphoric days in the late stages of the 1990s Tech Bubble reached greater heights. Overconfidence has typically only been relieved by a recession (highlighted in grey).
Investors are often surprised that we consider the extreme confidence we are seeing to be a negative indicator. In the past, bull markets have almost always peaked when economic news is the rosiest and consumer confidence the highest. When consumer confidence peaks and starts to waver, it’s time to be wary.
As Warren Buffet says, “Be fearful when others are greedy and greedy when others are fearful.”
Small Business and CEO Confidence
Let’s take a look at the correlation between individual consumer confidence and small business sentiment, by overlaying the National Federation of Independent Business (NFIB) Small Business Optimism Index. As the chart below illustrates, the two have tracked one another closely since the onset of the 2008 Financial Crisis.
Source: Jill Mislinski/Doug Short at Advisor Perspectives
As shown above, small business owners and CEOs are not quite as enthusiastic as consumers about their prospects.
Small business confidence fell sharply in the closing months of 2018 and has been slow to recover since. Business owners are most likely feeling the pressures of a tight labor market, rising wage pressures, higher materials costs; and squeezed profit margins. That could spell trouble for earnings and business spending ahead.
While confidence has clearly returned to the stock market, there are early signs of doubts and an ominous recessionary harbinger (described below) that’s too reliable for seasoned investors to ignore.
For the time being, the bullish dynamic that shot the markets straight up out of the gate in January has started to abate. The S&P ended May down -6.58% from the record high that began the month but still up a comfortable + 9.78% year to date.
For our part, we tend to view pullbacks during unsustainable rallies as necessary and natural “refreshment breaks.” In past articles we have often pointed out that “summer swoons” have occurred with enough regularity to create an old market axiom: “Sell in May and Walk Away.”
While we don’t subscribe to axioms, we have noted over the years that about 70% of stock market gains have been made during the cold weather months. We attribute this more to business patterns rather than weather patterns.
Market technicians tend to view the 50 day (purple) and 200 day (yellow) moving average lines as the demarcation between bullish and bearish momentum in the S&P 500.
Although a new market high was achieved in May, it failed to hold as the realities of an expanding trade war and heightened “sabre rattling” toward Iran sets in. As of Friday’s close at 2752 the S&P 500 is trading just below its 200-day moving average (yellow line) at 2,776 on the chart above.
A breach below this point would signal a “correction” is under way.
In a booming economy with unemployment near record lows, it undoubtedly seems odd to most investors that stocks are not roaring higher. But there are underlying forces at work that are pressuring corporate profit margins and raising debt to dangerous levels. Based on this and other late-cycle evidence, we are compelled to keep defensive and “de-risking” measures in place as this mature bull market moves into overtime… even if that means leaving a little of the profit potential on the table.
In the meantime, bonds trounced stocks in May
After a losing 2018, the bond market picture has obviously improved.
While nothing much has happened to the Fed rates recently, the demand for long term bonds has increased to the point that bond issuers can lower the interest rates they pay investors. As interest rates decline, the value of bonds rises in teeter-totter like action.
The exchange-traded iShares 20+ Year Treasury Bond fund (TLT), has gained 4.9% since May 3, compared with a negative -5.7% return for the S&P 500 and a negative -5.5% return for the Dow Jones Industrial Average during the same time period.
The chart above illustrates the widening divergence that has been taking place since the President’s market jarring May 5th tweet (box above).
There is quite a difference in the paths of the S&P 500 (red line) and the bond market (blue line) during the month of May. The bullish dynamic that propelled the S&P 500 to new heights may be unravelling as the result of renewed trade-war fears.
President Trump’s May 5th comments seem to suggest that he believes China and other countries are paying the billions and billions of tariff dollars flowing into the U.S Treasury. Thomas Donohue, president of the U.S. Chamber of Commerce, was quick to point out in his annual “State of American Business” address last week that China is not paying any of the tariffs on the Chinese made products imported by Americans:
“Let me be very clear: Tariffs are taxes paid by American families and American businesses -- not by foreigners,’’ he said.
The US has only minor trade imbalances with Europe, Latin America and Japan. However, the United States imports over $500 billion in goods and services from China and we ship $130 billion to them. The U.S. has already proposed tariffs on $50 billion in goods and threatened $200 billion more according to recent reports. China is retaliating.
Besides a protracted trade dispute with China, the Trump administration is opening several other battles, removing India from a privileged-trading program and pushing tariffs on Mexico unless it addresses the southern border.
How other markets have fared in May:
The Dow Jones Transportation Average (DJT) is down 9.3% since early May.
The small-capitalization Russell 2000 index should be more resilient to trade-war issues but tend to reflect growing domestic slowdown worries. It has fallen nearly 8% since May 3 and is off more than 14% from its August 31 peak.
The Stoxx Europe 600 Index (SXXP) is down 10.5% since its April 15 peak and off 5.1% since early May. Meanwhile, yields on German 10-year bonds, a proxy for the health of the European economy, have deepened their slide, yielding negative 0.18% compared with a yield at 0.02% on May 3.
In Asia, the Shanghai Composite Index has declined by 5.3% in May while China’s benchmark CSI 300 Index has declined by 6.4% over the same period.
The major international indexes are up substantially for the year. However, at the moment, we believe the biggest economic threat to global markets to be Europe.
Last year, Europe was showing real growth of close to 2%. Emmanuel Macron and Angela Merkel were providing strong leadership and the European Union seemed likely to endure for an indefinite period. All of that seems to have changed since the summer of 2017.
Populism has continued to spread. Merkel’s power has been diminished as her party lost seats in Parliament, and she has had to cobble together an unlikely coalition.
The Italian election has brought leaders into government who support a flat tax and guaranteed income for all citizens and believe these can be achieved without increasing the already large budget deficit.
The United Kingdom has failed to negotiate a “soft” break with Europe and sent Teresa May packing, but that objective is still in doubt. The strong growth that Europe was enjoying in 2017 has substantially fallen off, and George Soros has written that Europe is facing an “existential crisis.”
Everyone recognizes that governmental monetary expansion around the world has played an important role in financial markets during the decade. However, in Europe, sovereign interest rates are still negative. In fact, 29% of the bonds in the world have negative nominal interest rates.
The Inversion Conundrum
Do you hear the market’s tornado siren?
It’s been blaring for weeks. It’s called a “Yield Curve Inversion” and it is one of the most historically reliable precursors to an economic recession. An inversion of yields for 10-year Treasury bonds and 3-month T-Bills is a big deal. It means that the interest rate on very short-term treasury bonds is higher than the interest rate on very long-term bonds.
Recently, the 10-year Treasury note yield (red line) fell below the yield on the 3-month Treasury bill (green line) for the first time since 2007. The difference between the yield on the longer-dated Treasury bonds vs. its shorter-dated counterpart is closely monitored by investors. The resulting anomaly is referred to as an inversion of the yield curve.
Rate inversions are rare because investors normally tend to demand higher yields for extending loans over a longer period. Therefore, when rates invert it is viewed as a signal that an economic recession is likely waiting in the wings.
What Does an Inverted Yield Curve Suggest?
When the spread between short-term and long-term interest rates narrows, the yield curve begins to flatten. A flat yield curve is often seen during transition from a normal yield curve to an inverted one.
Because changes in the value of longer-term securities are more unpredictable buyers usually require a higher interest rate or maturity risk premium. Yields are normally higher on fixed-income securities with longer maturity dates. The further you go out on the “yield curve” to maturity, the higher should be your interest rate.
Historically, an inverted yield curve has been viewed as an indicator of a pending economic recession. One reason is that a curve inversion is an unnatural state for an economy to be in. Why would an investor buy a 10-yr bond when she could get a higher interest rate from a 90-day Treasury bill? A likely explanation is that inversions happen when investors believe that a recession may be coming. They seek shelter in the safest investment of all - the 10-year Treasury bond.
The rate on the 10-year bond is set by the market--supply and demand. The Fed Funds rate is set by bureaucrats at the Federal Reserve.
When investors are scared, they run to the safety of the 10-year bond. When the Fed is scared, they raise short-term rates to cool down the economy and prevent runaway inflation. These two forces collide to produce an inverted yield curve.
Do Inverted Yield Curves Cause Recessions?
To be clear, an inversion of the yield curve does not cause a recession and a bear market does not always accompany a recession. Rather, it is a warning of an advancing change in the financial environment that may carry serious consequences for the U.S. economy.
Past performance is no guarantee of future performance. Note that Fed interest rates have never been as low as they are today. The Fed’s action in reversing its position on interest rate increases sent all interest rates plummeting. T-bills couldn’t fall very far. It’s possible the inverted yield curve is an unintended consequence of that move rather than a harbinger of bad things to come.
How Might a Recession Affect the Stock Market?
This is the first inversion to occur since 2007. An inversion has preceded each of the last seven economic downturns. The only exception was 1966. At that time, a recession did not occur, but a bear market did--just one month later according to InvesTech Research.
While an inverted yield curve doesn’t cause a recession; it has been a good indicator that one may be coming. The good news is that if a recession is coming, it is not imminent and favorable conditions often prevail for some time after the yield curve inversion.
It's important to note that there is often a significant lag between the first inversion date and the onset of the recession. The average lag time is 14 months.
There is a big difference between the lag times for recessions to begin versus the beginning of a bear market contraction. The stock market usually begins to “top out” well ahead of recessions. In fact, a major stock market downturn is one of the government’s leading “early-warning” recessionary indicators
The table above shows the lag between inversions and market tops.
On average, it only takes 8 months for a bull market to top out after an inversion occurs. Just remember that the stock market will be out ahead of the economic downturn. While things may indeed be different this time, investors need to weigh how much they want to wager on the market while this harbinger of recession is sounding.
Economic cycles, regardless of their duration, have historically transitioned from expansion to contraction and back again. Likewise, stock markets cycle from bull market expansion to bear market contraction and back; The two cycles are not always in sync. It should be noted as well, that major bear market downturns have not always led to a recession.
Blame it on trade-war fears; the inverted yield curve; or peg it to worries that the global economy is facing a pronounced slowdown. In any case, there are growing concerns about the economic picture and the sustainability of the 10-year-old bull run for stocks. We note that our bull-bear indicator remains positive for the long term. While we want to give this bull market every benefit of doubt, our position is that this remains a late-stage bull market, and investors should be ultra-careful.
We think our clients will ultimately be pleased that we took some profits in 2018 with the S&P just 7% off its all-time high. Another leg up in this market in 2019 would present us with an ideal opportunity to take some more profits.
Source: All data for the discussion of Yield Curve Inversion has been provided by Investopedia public access website.
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