The financial markets have been telling a fragmented story ever since the beginning of 2019, but that appears to be changing. Over the past month, the messages coming from stock and bond markets have begun to coalesce in a manner that unfortunately, will likely leave a bearish taste in your mouth.
Originally pointed out on March 5th, and then again revisited on March 26th, the first four months of this year have seen an incredible divergence between stock prices and bond yields. Here’s a quick chart showing the performance of the S&P 500 vs. the 10-year Treasury yield through the end of April.
Notice that during this period, the stock market went straight up – reflecting improving growth prospects, while long-term interest rates when straight down – reflecting deteriorating economic conditions.
When this happens, the question always becomes: Who’s smarter, the bond market or the stock market? And as most of you know, the answer to that is invariably the bond market.
Fast forward another month, and this is what the picture looks like now:
As you can see, longer-term Treasury yields have continued to fall, and lo-and-behold, the stock market is finally beginning to take notice. Recent declines in the S&P have taken the index right back to its major support/resistance line (pictured in the top panel), which has been a key battleground for the past eight months.
The most recent price action saw the S&P test that (now support) level in early May, and again just two days ago on May 23rd. So far it has held, but notice above that we’ve traced out what appears to be a head-and-shoulders topping pattern during March, April and May. A break below the neckline, which now corresponds with our major support/resistance level just above 2800, could send the market lower in the weeks ahead.
As for bond yields, take another look at that incredible chart in the lower panel above. In just seven months, the yield on the benchmark 10-year note has fallen from 3.2% to 2.2%. That represents a decline in borrowing costs of over 30%.
This will certainly have a stimulatory effect on lending, and should provide some nice help to mortgage and real estate markets, but this precipitous drop in interest rates is a sign of greater malaise within the global economy. In case you’re wondering, it’s not just our sovereign rates that have fallen; Germany’s 10-year bund now trades in negative territory again (-0.16%), as does Japan’s 10-year bond (-0.07%).
So in essence, the bond market has been signaling a resumption of deflationary forces and tough times ahead, while the stock market has been happy to dance the night away.
In fact, longer-term bond yields here in the U.S. have fallen so far that we once again have an inverted yield curve across key maturities. Notice in the chart below that while short-term T-bill rates have remained steady (as a result of the Fed keeping the Fed Funds rate at current levels), longer maturities (2–10 year notes) have fallen in yield.
This is a sign that investors are concerned about growth prospects in the near-term and are looking to lock up their money in advance of approaching storms.
As a quick side note, I know that many folks in the investor community discounted previous yield-curve inversions because they were either in the belly of the curve (not across key maturities), or because those that did occur across key maturities (for example, the 10-year minus 3-month) were very short-lived. This resumption, and near complete inversion of the curve, should reinforce the fact that one of the most reliable recession warnings in history is flashing “danger.”
Of course, to be fair, the yield-curve has a long lead time with regard to predicating recessions, so we don’t need to make any drastic moves yet, but we do need to maintain an awareness of the environment that we’re operating in.
Before we move on, I thought I’d show you this quick chart from the New York Federal Reserve Bank. It shows their recession probability model (based on the slope of the yield curve) and as you can see, it’s suggesting a 27.5% chance of recession in April of 2020.
These models aren’t perfectly accurate, but one thing I find interesting is this: At the current probability level (27.5%), there has only been one false-positive in the last 80 years where a recession didn’t occur, and that was back in 1967. Other than that, every time this particular model has reached its current level, we’ve seen an ensuing recession.
Now, there’s a caveat to everything and in this case one of the big caveats is that the cost of money (interest rates) have rarely been this low in history. This means that we’re operating much closer to the zero-bound across all maturities, and as a result, yield-curve slope inferences may be distorted. That said, I’m still not going to utter those famous last words, “this time is different.”
But I will present some “alternative facts” … (just kidding, these are good old fashioned real facts) that do tell a different story.
The slope of the yield curve is one of the 10 components of The Conference Board’s Leading Economic Index, and yet that particular index (shown below) has seen a resumption in growth. After flatlining for about five months, the LEI has increased in each of the last three months, rising 0.2% in April.
Like the yield curve itself, this metric has a good history of forecasting recessions, and it also provides a long lead time. Thus, we have the yield curve saying, “danger ahead,” while The Conference Board’s LEI says, “eh, don’t worry so much … everything will be fine.”
Whenever we get conflicting signals like this, it’s a good idea to look below the surface and we can do that with respect to the LEI. According to Ataman Ozyildirim, Director of Research for The Conference Board, “Stock prices, financial conditions, and consumers’ outlook for the economy buoyed the US LEI [in April], although the manufacturing sector showed continuing weakness.”
Interestingly, those three factors (stock prices, financial conditions and consumers’ outlook) are all somewhat fickle metrics. Stock prices did indeed climb in April, perhaps as a result of both momentum and a continued rebound from oversold levels, while financial conditions will appear to have improved largely because interest rates have fallen and spreads have not spiked. As for consumers’ outlook, many argue that this is really just a proxy for the S&P 500, as most consumers base their outlook for the economy on how the stock market is doing.
So if, in fact, these pillars of recent strength in the LEI are disguising weakness elsewhere, we could see the LEI move lower in the months ahead. At least that would give us some sense of congruency with regard to other metrics.
Part of the reason I think that could be the case is because we’re seeing many economic indicators continue to weaken. The chart below shows the Markit Composite PMI for the U.S., and as you can see, we’re getting darn close to that 50 level that separates contraction from expansion.
What’s particularly concerning about this latest reading (keep in mind this is the flash reading, which will get revised as more data comes in) is that the services component came in at 50.9, which is the lowest level in 39 months (it was at 53.0 last month). Services account for roughly 80% of our economy and they’ve been the resilient component so far, while manufacturing has slowed. If this trend in services continues, it portends bad things ahead.
In addition, the J.P. Morgan Global PMI figures also continue to deteriorate. Manufacturing (the thin dark line) has been hit the hardest, while global services (thin gray line) has helped to buoy the composite data (thick black line).
This data is not pointing to a global recession by any means, but don’t forget how volatile the stock market was during 2015 and early-2016 in response to the deterioration we saw then. It would not surprise me to see volatility pick up again here soon, especially if we don’t see any progress made on the trade front.
Two other recent data points I thought I would share include the continued decline in Industrial Production (growth has been negative in three out of the last four months, and year-over year growth is almost nil) …
And durable goods orders, which are also rolling over on a year-over-year basis.
Overall, while a recession is not necessarily knocking on our door (it’s still knocking on the neighbor down the street’s door), the trend in most economic data continues to point toward moderating growth. As a result, I still believe we may continue to be in a difficult, trading-range style environment for some time.
This type of environment warrants modest allocations to equities, which can be supplemented by trading around a core position. Other alternatives for generating some alpha include renting out stocks to collect income via covered calls, or selling puts to generate income while waiting for prices to come in further.
I still don’t think we’ve seen the end of this current correction, so if you have raised cash I would hold off on putting it back to work, especially in light of the precarious position many major averages sit at.
We saw the developing head-and-shoulders in the S&P 500 already, where we’re hovering just barely above support, but other index are seeing similar developments.
In the chart below we can see that small-caps are also testing their long-term support …
And both the Industrials (top panel below) and Transports (lower panel) are also on the verge of collapsing below key support levels.
As I mentioned earlier, if all these various support levels are breached, we will most likely see momentum continue to the downside.
Since most of today’s note has been on the bearish side, I’ll leave you with one good morsel of bullishness … the NYSE Advance-Decline Line. As you can see below, market breadth remains strong, albeit not at new highs.
But don’t let this chart fool you … the short-term trend remains bearish, confirmed again by today’s late-day selloff.