Published March 2, 2018
This week we share some good information from a webcast given by Charlie Bilello of Pension Partners. The first chart shows the downward trend of the 10-year U.S. Treasury yield. Note the green arrows as the yield hits the upper portion of the channel. We are sitting right at the top of the channel. Do we want to see yields break through to the upside?
History suggests YES WE DO!! Failure to break through to the upside has actually preceded some serious stock market declines as shown below:
Rising rates, with low inflation, as we have now, suggests strong economic growth. That generally is positive for stocks unless investor sentiment flips to being sour on stocks. So a failure to break higher in interest rates would mean that something has changed in a negative way – either economically or in investor sentiment.
The Federal Reserve is expected to raise short-term interest rates three times this year. If 10-year yields stop rising here, then something has happened to completely reverse the Fed’s view of the world; OR investors have become seriously concerned about the outlook for the economy, believing that growth is suspect beyond the next year or so. If investors adopt that narrative and keep 10-year rates in check while short-term rates ramp upward, the yield curve would flatten substantially and perhaps invert where short-term rates are higher than longer-term rates. An inverted yield curve is a strong predictor of an impending recession. That would definitely be bad news for stock prices.
The beginning of February saw one of the worst weeks in the stock market in quite some time. That week made the top 20 of bad weeks over the past 15+ years. Note that almost half of these instances occurred during the 2008-2009 financial crisis/bear market. Since the brief bear market of 2011, there have only been two other weeks experiencing a decline of -5% or more. The February decline was notable for bonds ALSO FALLING. Bonds are usually where the money flows when stocks are rocked, causing bond prices to rise and deliver positive returns when stocks falter. Not this time as bonds also tumbled. This stock-bond jump off the cliff together has only been seen one other time in the past 15+ years (during by far the worst week back in 2008).
Expanding on the idea of stocks and bonds being uncorrelated assets, where bonds rise when stocks fall, we see that on an annual basis the two asset classes posting negative years IN THE SAME YEAR has only happened three times in the past 90 years. And it’s been almost 50 years since that last occurred. The odds are very slim we see stocks and bonds both issue losses in the same year. 14% of the time rising rates send bonds down for the year while stocks post a gain, with recent instances being very strong years for stocks.
As the market this week shows that it is still wrestling with the after effects of the steep market correction at the beginning of February, we note that there have been over 20 cases of -5% or greater market declines since the launch off the 2009 market lows. The 18 month grace period we just completed, where stocks never had a -5% move, is extremely unusual. We typically have at least one decline of this magnitude each year, with the market spending a month, on average, working to regain its footing.
We have stocks and bonds at a crossroads here. History tells us we want interest rates to break out of their 30-year channel as doing so would imply a strong enough economy to warrant higher rates. Those higher rates don’t necessarily spell doom for stock prices. In fact, history says there is only a 3% chance that a weak year in bonds will lead to a losing year in stocks. A few years ago investors were anxiously awaiting the great shift in assets where money would flow from bonds to stocks as higher interest rates finally break the decades long bull market in bonds. That shift would push stock prices higher. Are we finally on the verge of that great shift? If so, no one seems to be talking about it, certainly nothing like they were a few years ago. Keep an eye on that 10-year Treasury yield for a key clue as to the fate of markets!
Stocks endured another difficult week as investors sought to understand new Fed Chair Powell’s outlook on the pace of interest rate hikes. Monday’s trade was a bright spot for bulls, building on the prior Friday’s strong showing. Stocks pushed higher by +1.2% leaving the Nasdaq having recovered all of its early February selloff. The good feeling vanished Tuesday, however, as Mr. Powell’s first testimony before Congress was viewed as opening the door to a faster pace of interest rate hikes by the Fed. Stocks dove after his testimony to a -1.3% loss. An increased bid for British broadcaster, Sky, sent shares of bidder Comcast (CMCSA) and Dow component Disney (DIS) down sharply. Comcast is a top 10 holding in the Nasdaq 100 (QQQ). Yet, at a 2% weight in the index, the company has little effect. Apple (AAPL), Microsoft (MSFT), Amazon (AMZN) and Alphabet (GOOGL) comprise a massive 40% of the QQQ these days. A slight effort to rebound on Wednesday was met with more selling. Stocks again closed the day very near their worst levels of the day after a -1.1% slide. The weakness in stocks pushed money into bonds, bringing the 10-year Treasury yield back under 2.9%. Stock investors kicked off the month of March Thursday with a positive push at the open. However, the rug was pulled out from under the stock market in the afternoon when President Trump announced tariffs on steel and aluminum. The announcement sparked fears of a trade war sending stocks down over -2% at their worst levels before a modest rebound left the indexes down -1.3%, the third straight day of heavy selling. Bond yields unwound some of their February rise on the stock selloff with 10-year yields settling at 2.81%. The trade fears pushed stocks down further at Friday’s market open before buyers stepped in to provide support at the Nasdaq 100’s 50-day moving average. Small-caps lifted solidly in a rare effort to offer market leadership from this long lagging group. However the group’s rise was capped at its 50-day moving average.
The stock market’s recovery from early February’s market correction encountered new and heavy resistance this week as three days of heavy selling left indexes struggling to regain their footing. The S&P 500 (SPY) slid -2.05% while the Nasdaq 100 (QQQ) fell -1.30%. The Nasdaq was the only index to remain above its 50-day moving average and offer some hope to bulls. The Russell 2000 small-cap index (IWM) gave up -1.06%.
Warm wishes and until next week.