Before we get started today, I want to mention that thanks to one of our key software developers, we’ve been able to upload nearly all my past commentary from DTL on to the Sigma Point website. Not only are the previous articles now available for you to peruse, they’ve been categorized and dated appropriately, and are searchable using the search function to your left.
This means you can go back and reread everything I’ve written over the past 6+ years, and even call me out on instances when I’ve been wrong (what better way to learn from my mistakes, right?). I’m excited that this content is now preserved indefinitely and hope that you find it useful.
Okay, we’ve got a lot to cover today, so let’s jump right in. The first thing I’d like to touch on is the change in communication from Fed Chairman Jerome Powell.
Back on October 3rd, Mr. Powell made what I believe to be a grave mistake by stating that the federal funds rate remained a “long way from neutral.” If the market generally behaved as an adult, comments like this would be fine, as all relevant market participants are aware of the dot plot and related communications that ultimately frame his outlook.
But unfortunately, over the short-run the market tends to behave more like a moody teenage girl than a wise arbiter of prices. It gets emotional, throws tantrums, and whines incessantly about policy changes and other developments. We also have the algos to contend with, with their dry, non-contextual reading of headlines and tweets and whatever else happens to be fed into the black box.
From my perspective, if there’s one thing that EVERY market participant is aware of, it’s the fact that the Fed has killed most economic expansions or at least been complicit in their demise. Thus, when global economic data is beginning to deteriorate, we’re in the middle of a trade war, previous rate hikes haven’t yet made their way through the system, AND the Fed says we still have a “long way” to go … it scares our poor little adolescent market.
In the chart below you can see the exact day that Powell’s comments were made.
But thankfully, in a speech to the Economic Club of New York, Powell walked back that statement by restating that rates are “just below” neutral. I listened to a few well respected economists (who I generally tend to agree with) argue that both statements are in effect the same, but I completely disagree.
With the Fed’s history of overtightening, investors are hypersensitive to this topic. The Fed can claim data dependence all it wants, but at the end of the day, it’s the FOMC’s interpretation of the data that matters, not the data itself. And in my mind, “long way” and “just below” are as different as night and day.
So the good news is that it appears Mr. Powell gets it, and probably won’t make a mistake like that again. Also, to be clear, the projected rate path did not change between his comments. All that changed was how his viewpoint was “framed.” Ah, fickle markets.
Moving on, and continuing our discussion of rates, we recently saw a minor inversion in the yield curve. Specifically, the yield on 5-year Treasuries fell below that of 2-year notes.
I’ve written extensively about the yield curve over the years and generally speaking, the spreads that investors pay most attention to are the 10-year minus 3-month and 10-year minus 2-year. Both of these spreads are still positive, which is leading to some calls that this is merely a blip caused by supply and demand imbalances. I’m not so dismissive.
In the chart below, we can see both the 5-year minus 2-year spread, as well as the 10-year minus 2-year. While the 10’s-2’s spread is a bit more accurate (it didn’t exhibit a false positive back in 1998), I think it’s quite evident that the 5’s-2’s spread is still very good at predicting the onset of a recession.
In addition, the 10’s-2’s spread has now fallen to below 20 basis points … less than the equivalent of one quarter point rate hike.
There are counter arguments to be made that suggest this time may be different, but from my perspective, when the term premium on any longer dated note goes negative, it’s an ominous sign.
Effectively what investors are now saying is that they’ll willingly take a lower return to have their money locked up for 5-years than they would to lock their money away safely for two years. In other words, I’ll pay money (forgo additional compensation) to NOT have to reinvest my treasury holdings in two years.
Why would an investor do that? The only logical reason is because they believe economic conditions in two years may not be as favorable as they are now. Weaker economic conditions would come with lower interest rates, and therefore the reinvestment of that capital in two years would generate less yield than is available now.
A few weeks ago, after I wrote the article titled, “Dow Theory ‘Lines in the Sand’ Have been Drawn” one subscriber wrote in and asked exactly what the criteria are that would cause me to become bearish. Is a Dow Theory sell signal enough to get me to switch? Or something else?
My response, which I’ll elaborate on here, was that I tend to look for confirmation across a wide variety of economic, fundamental and technical factors. Dow Theory turning bearish definitely holds weight, but it’s only one tool in the market analysis tool box. Other factors, such as the yield curve and other leading indicators, also play a role in determining the big picture.
In a sense, what I’m looking for is confirmation not just across two price averages, but across a plethora of historically reliable indicators. When I begin to see bearish indications arise from disparate sections of the financial markets, it’s a sign that something big is happening.
And unfortunately, it appears that we may be entering that type of environment. In my article from two weeks ago, I stated that what bothered me more about this current correction was not really the correction itself, but the fact that absolute momentum on a longer-term basis was now flat to negative. Over a period of nearly a year, the stock market has gone nowhere.
That has precarious implications, especially when you consider the strong earnings growth that has amassed beneath the surface. In essence, what’s happened is that investors are no longer willing to pay up for earnings because they’re not convinced those earnings will hold up. Either the earnings themselves will deteriorate, or the stream of cash flows will not be as valuable because the discount rate used to bring that stream of cash back to its present value will have risen.
That’s a powerful signal from the stock market, and now we’re getting perhaps just as powerful a signal from the bond market. It’s a one-two punch with potentially serious consequences.
One of the wisest adages on Wall Street is: Be quick to turn bullish, slow to turn bearish. I am not in the bearish camp quite yet, but the message from both the stock and bond markets can’t be ignored. As a result, I think it’s time to begin operating in a slightly more conservative manner.
That doesn’t mean sell everything, but it does warrant potentially reducing exposure if you feel overweight equities. It also means that moving forward you should be less inclined to buy the dips and more apt to sell into rallies.
It’s important to remember that yield curve inversions typically lead economic recessions by 6-12 months, sometimes longer. When you also take into account the fact that the stock market discounts future economic conditions and peaks before the official onset of a recession, it means that the stock market’s ultimate peak could roughly coincide with an inversion of the curve.
So it’s possible that the September peak was THE peak, but I’m still doubtful. That said, I think it’s important to frame out what exiting the stock market in a prudent fashion looks like. We will never nail the exact top, but from my perspective, if you can liquidate the majority of your positions within 10% of the market’s high water mark, you did extremely well.
Right now, even after today’s pummeling, the S&P sits about 7.5% off its highs. Thus, reducing exposure at these levels would be very satisfactory IF the September high ends up holding. My suggestion is to reduce exposure here slightly on any coming rallies as we await further data on the direction of the economy.
Before we wrap things up I want to provide a quick update on Dow Theory. As you can see below, the Industrials (top panel) did break below their late October low momentarily, but the Transports did not.
As it stands, this is actually a positive sign as it represents a bullish non-confirmation. The Transports have so far refused to confirm the bearish action in the Industrials. That could change quickly, however, so we’ll need to keep monitoring.