Inverted Yield Curve Deepens As Recession Risks Rise
Inside This Week’s Bull Bear Report
- Market Rally Pauses As Fed Talks Tough
- Inverted Yield Curves Increase Recession Risk
- How We Are Trading It
- Research Report – Hard Landing Coming?
- Youtube – Economic & Market Q&A With Lance Roberts
- Stock Of The Week
- Daily Commentary Bits
- Market Statistics
- Stock Screens
- Portfolio Trades This Week
Market Rally Pauses As Fed Talks Tough
Last week, we discussed the market rally following the weak inflation print.
“From a technical perspective, the market tested and held crucial support again at the 20-dma after the FTX (cryptocurrency) blowup on Wednesday. The subsequent rally off support turned our MACD “buy signal” higher, keeping it intact, and the market cleared critical resistance at the 100-dma. Such now sets the stage for a rally to the 200-dma between 4000 and 4100.”
This week, the market touched our initial objective of 4000, but as we will discuss momentarily, tough talk from Federal Reserve officials knocked the markets back a bit. However, despite those comments, the sell-off was mild, holding above critical supports heading into the holiday-shortened and light volume trading week where the “inmates will run the asylum.”
The good news is that the market tested, and held, 100-dma with the 20-dma crossing above the 50-dma. With the market contained in a rising trend channel, this all suggests the bulls remain in control for the time being. Speaking of “inmates,” the net bullishness of investors is now at the highest level since the July market peak.
With next week a holiday-shortened trading week, a continued advance through the end of the month is likely.
However, there is a problem with this bullishness as the market rally works against the Fed’s goal of tightening monetary policy to reduce inflationary pressures. Such was why we saw various Fed speakers out this past week trying to talk the market lower.
“Somewhere between 4.75 and 5.25 seems a reasonable place to think about as we go into the next meeting. And so that does put it in the line of sight that we would get to a point where we would raise and hold. Pausing is off the table right now, it’s not even part of the discussion. Right now, the discussion is, rightly, in slowing the pace.” – Mary Daly To CNBC
The tough talk is an attempt to reduce the market’s continued hope for a “pivot” in Fed policy. The problem with a Fed “pivot,” as discussed below, is that such will likely occur when it is least bullish for equities. To get inflation under control, the Fed must contract economic activity. Such is already happening and is beginning to show in deepening inverted yield curves.
At nearly 8% inflation, the Fed is not close to a pivot with unemployment at historically low levels. As such, investors need to pay attention to what the yield curves are suggesting.
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Inverted Yield Curve Deepens
On Thursday, St. Louis Federal Reserve President James Bullard said the central bank still has a lot of work to do.
“Thus far, the change in the monetary policy stance appears to have had only limited effects on observed inflation, but market pricing suggests disinflation is expected in 2023. The policy rate is not yet in a zone that may be considered sufficiently restrictive. To attain a sufficiently restrictive level, the policy rate will need to be increased further.” – CNBC
Such is an important statement given current economic conditions. The Federal Reserve controls the short-end of the yield curve (1-month to 2-year rates.) However, the economy, wages, and inflation control the long end of the curve. Therefore, as the Fed continues to hike rates, such will increase the number, and the depth, of inverted yield curves. Notably, the inversion of various yield curves is essential to both market outcomes and the economy (aka recession).
As discussed previously, we monitor ten economically significant yield spreads. Notably, it is not just the inverted yield of the 10-year versus 2-year Treasury bonds that signal a recession, but rather when a majority of yield spreads track invert. More importantly, as shown, the inverted yield spreads only signal a recession is approaching. It is when the yield curves UN-invert that denotes the arrival of the recession.
Such is because, at that moment, the short end of the yield curve is falling faster than the long end of the curve as the Fed starts cutting rates. Historically, these rapid cuts in the Fed Funds rate coincide with the onset of a recession as the Fed acts to provide monetary accommodation.
However, “this time seems different” as the Fed hikes rates, but economic data like employment, GDP growth, and retail sales appear strong. Such seems to suggest the Fed’s rate hikes are not grossly impacting economic strength, and the fabled “soft landing” might be obtainable.
Economic Data Says “No” Recession
When looking at economic statistics, it certainly appears to be little risk of recession. The 6-charts below are the economic measures most viewed by economists.
Clearly, there are NO signs of recession:
- 5% annualized real personal income growth
- 2.6% annualized employment growth
- 4.8% annualized industrial production growth
- 11.5% annualized real PCE growth
- 13.4% annualized real wage growth
- 4.8% annualized real GDP.
Yet, the yield curve is inverting.
So, which indicator is right?
Should you be betting on the economic data or the “yield curve?”
My apologies. I forgot to add the X-Axis to the charts above. (Not really, it was intentional)
That time frame is 1991 through 1999.
I don’t need to remind you what happened next.
How about the stats in December 2007, when the next recession officially started?
- 1.4% annualized real personal income growth
- 0.8% annualized employment growth
- 2.2% annualized industrial production growth
- 4.6% annualized real personal consumption expenditure growth
- 5.7% annualized growth in real wages
- 2.0% annualized real GDP.
Again, there is no recession visible. Yet, the yield curve was sending a warning.
Notably, while investors are hoping for a “Fed Pivot” to boost stock prices, the inverted yield curves are warning differently.
Inverted Yield Curves And Market Outcomes
Since mainstream financial advice never suggests selling, investors didn’t realize going to cash in 1998 would save them years of losses to recover.
The “Dot.com” crash was considered a once-in-a-100-year event. Unfortunately, 4-years later, in 2006, the media again told investors to ignore the yield curve inversion. It was a “Goldilocks economy,” and “sub-prime mortgages were contained.”
For a second time, had investors sold when the yield curve inverted, the amount of damage avoided more than paid off for the small gains missed as the market peaked.
The quad-panel chart below shows the 4-previous periods where 50%, or more, of 10 different inverted yield curves occurred. I have drawn a horizontal red dashed line at the first point where 50% of the 10-yield curves tracked became inverted. I have also denoted the point you should have sold and the subsequent low.
In 2019, the yield curve inverted again, leading to a 35% correction and recession in 2020.
That’s just history
Once again, 60% of the 10-spreads we track are inverted. As such, the risk of a recessionary onset increases.
As the Fed continues to hike rates, more curves will invert. Currently, the Fed seems intent on doing just that.
While using the “yield curve” as a “market timing” tool is unwise, dismissing the message entirely is just as foolish.
Moreover, I do not suggest you sell everything and go to cash today. However, history is clear that you will likely not miss much if you do.
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How We Are Trading It
This week’s message is central to our core investment philosophy of heeding risks as they develop. As noted, we are becoming increasingly cautious in portfolios with 60% of the tracked yields inverted. This past week we further reduced equity allocations and increased cash levels as the market rallied toward our initial targets.
As the Fed engages in its most aggressive monetary tightening campaign in history, from hiking rates to reducing its balance sheet, such will impact economic activity next year. The continued extraction of liquidity from the markets historically aligns with deeper market corrections, credit-related events, or recessions. There is little reason to expect this time will be different.
We continue to pay attention to what the market is telling us. The rally we expected finally materialized. We previously suggested using any rally to rebalance risk, adjust allocations, and reconsider investment strategies as we deal with a changing environment.
From that view, we have previously rebalanced our energy exposures and reduced more aggressive growth names. This week, we trimmed back positions with significant runs outside their relative risk ranges. Those changes keep us significantly underweighting equity risk with sizable cash holdings to protect client portfolios against further market weakness.
With quarter-end rebalancing approaching, I would not be surprised to see a continued rally. However, as the Fed becomes more aggressive, I remain concerned there could be a sizable increase in volatility.
Continue to follow the basic portfolio management guidelines for now.
- Tighten up stop-loss levels to current support levels for each position.
- Hedge portfolios against significant market declines.
- Take profits in positions that have been big winners
- Sell laggards and losers.
- Raise cash and rebalance portfolios to target weightings.
See you next week.
Market Recap – Economic & Market Outlook 2023
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Stock Of The Week In Review
Using the SimpleVisor screening tool, this week’s scan starts with the 2022 large-cap underperformers to find those that surged on last week’s lower-than-expected CPI report. Like last week, our goal is to isolate the stocks which may outperform when inflation falls, and the Fed starts to signal they are likely to pivot.
Six stocks were up over 20% from November 10 through November 14. Despite the massive price gains, the stocks are still down over 40% year to date. This screen does not consider fundamental or technical analysis.
**In the SimpleVisor Equity Portfolio, we reduced our exposure in NVDA and AMD on November 14th. The trades were due to the large price increases and the ensuing overbought technical condition.
Here is a link to the full SimpleVisor Article For Step-By-Step Screening Instructions.
Here is one of the stocks from the scan.
Login to Simplevisor.com to read the full 5-For-Friday report.
Daily Commentary Bits
A Bearish Signal with Bullish Implications
The graph below plots the number of positive trading days per the prior 252-day periods going back 50 years. Over the last 252 trading days, only 111 days, or 44%, have been positive. The red diamonds highlight that such a low occurrence has only happened three other times, two of which were over 40 years ago. From oldest to newest, the annual return for the next 252 trading days following those highlighted lows are as follows: +28.02%, +57.73%, and +40.36%. Therefore, we may have quite a rally in the coming year if this indicator proves worthy.
Click Here To Read The Latest Daily Market Commentary (Subscribe For Pre-Market Email)
Bull Bear Report Market Statistics & Screens
SimpleVisor Top & Bottom Performers By Sector
S&P 500 Tear Sheet
Relative Performance Analysis
As we stated last week, the weaker inflation data sparked a “bid to cover” the most shorted and hated equity names.
“The sharp move has pushed most markets and sectors into extremely overbought territory, suggesting some profit-taking is likely well warranted.“
Such is what we saw this past week, but we could see some additional drift in the upcoming holiday-shortened week as many markets remain near overbought territory.
The technical overbought/sold gauge comprises several price indicators (RSI, Williams %R, etc.), measured using “weekly” closing price data. Readings above “80” are considered overbought, and below “20” are oversold. Markets tend to peak when readings are at 80 or above, which suggests profit-taking and risk management are prudent. The best buying opportunities exist when readings are 20 or below.
The current reading is 47.66 out of a possible 100 and rising. Remain long equities for now.
Portfolio Positioning “Fear / Greed” Gauge
The “Fear/Greed” Gauge is how individual and professional investors are “positioning” themselves in the market based on their equity exposure. From a contrarian position, the higher the allocation to equities, the more likely the market is closer to a correction than not. The gauge uses weekly closing data.
NOTE: The Fear/Greed Index measures risk from 0 to 100. It is a rarity that it reaches levels above 90. The current reading is 57.65 out of a possible 100.
Sector Model Analysis & Risk Ranges
How To Read This Table
- The table compares the relative performance of each sector and market to the S&P 500 index.
- “MA XVER” (Moving Average Cross Over) is determined by the short-term weekly moving average crossing positively or negatively with the long-term weekly moving average.
- The risk range is a function of the month-end closing price and the “beta” of the sector or market. (Ranges reset on the 1st of each month)
- The table shows the price deviation above and below the weekly moving averages.
With the rally over the last few weeks, and particularly the surge following last week’s CPI report, many sectors are in more extreme overbought territory on a risk/reward basis. We suggested taking profits in last weekend’s missive and continue to suggest the same this week. While markets are currently performing well, these larger moves tend to result in some near-term correction processes.
Weekly SimpleVisor Stock Screens
Each week we will provide three different stock screens generated from SimpleVisor: (RIAPro.net subscribers use your current credentials to log in.)
This week we are scanning for the Top 20:
- Relative Strength Stocks
- Momentum Stocks
- Highest Rated Stocks
These screens generate portfolio ideas and serve as the starting point for further research.
(Click Images To Enlarge)
Highest Rated Stocks
SimpleVisor Portfolio Changes
We post all of our portfolio changes as they occur at SimpleVisor:
After the large jump in stocks last week, which pushed many stocks into more overbought short-term conditions, we are continuing to use the rally to reduce overall equity risk in portfolios as we head into year-end.
In the Equity model, we are reducing both of our chip stocks which have had huge reversals by 0.5% each, along with Albemarle (ALB) and Goldman Sachs (GS). In the ETF model, we are reducing Basic Materials (XLB), Industrials (XLI), and Financials (XLF) for the same reason.
We suspect the market will trade off some following the Thanksgiving holidays and into the first couple of weeks of December, where we will look to reallocate back into some of these positions if the opportunity presents itself.
- Reduce both Nvidia (NVDA) and AMD (AMD) by 0.5% each after a significant recent move.
- Take profits in Albemarle (ALB) after the recent surge and reduce position by 0.5% of the portfolio.
- Sell 0.5% of Goldman Sachs (GS) and take profits on the trade.
- Reduce Industrials (XLI) and Basic Materials (XLB) by 0.5% of the portfolio after the recent surge.
- Trim Financials (XLF) by 0.5% of the portfolio.
Lance Roberts, CIO
Have a great week!