How the stock market reacts after yield curve inversions


Everyone seems to be focused on the 10 year – 3 month yield curve inversion these days. To avoid repetition, this will be our last market analysis that mentions the yield curve for a while.

Go here to understand our fundamentals-driven long term outlook.
Let’s determine the stock market’s most probable medium term direction by objectively quantifying technical analysis. For reference, here’s the random probability of the U.S. stock market going up on any given day.

*Probability ≠ certainty. Past performance ≠ future performance. But if you don’t use the past as a guide, you are blindly “guessing” the future.

Housing Trouble

The biggest weak point in the economy is still housing. Housing is not improving.

Here’s what happens next to the S&P when Housing Starts’ 12 month moving average falls 5 consecutive months, while Unemployment is under 5% (i.e. late-cycle)

As you can see, this is how the 2007, 2000, 1973, and 1969 bear markets started (there was a lead time of 1+ years from 2006-2007).
But there were also false bearish signals in 1964 and 1966
Watch out if housing weakness persists over the next few months.

Best sector

CNBC had a good article today explaining which sectors perform best after yield curve inversions.

I took a look at the numbers to see which sectors perform best. Always do your own homework, never blindly trust someone else’s word.
Here’s what happens next to various sector ETFs after the first yield curve inversion in the previous 2 economic expansions.
*The data is only available from 1998-present. With n=2, take this with a grain of salt








It appears that XLU and XLP do perform quite well, which is probably why they’ve been ramping higher recently

Odd bedfellows

The recent stock market rally has been quite strong, with XLU (defensive stocks, XLK (high flying tech stocks), and RWR (real estate sector) all performing well.

This is remarkably different from the 2000-2002 and 2007-2009 bear market rallies. The 2000-2002 bear market saw incessant weakness in XLK (tech bust) and the 2007-2009 bear market saw incessant weakness in RWR (real estate bust).
Is this a bull market sign?
Here’s what happens next to the S&P 500 when the 10 year yield falls while XLU, XLK, and RWR all rally 10% over the past 3 months.

Sample size is small (n=4), but this is more bullish than bearish.

Germany vs. U.S.

I used to follow the German Dax back in 2012, when I still believed in traditional technical analysis. Like most traders, I would look for “divergences”. (It’s interesting that when most people see the S&P diverge with another market/indicator, they automatically assume that the S&P is “dumb money” and the other market/indicator is “smart money”).

The German DAX has significantly underperformed the S&P over the past 1.5 years, probably because the German economy is much weaker than the U.S. economy.
Does this mean that the S&P will “reconnect” with the DAX?
Here’s what happens next to the S&P when the DAX falls more than 9% over the past 1.5 years while the S&P rallies more than 12%.

This “decoupling” is clearly not consistently bearish for stocks.

China and commodities both doing well

The Chinese stock market and commodity prices have done well over the past 3 months, rallying together. The Chinese stock market often moves inline with commodities.
Stronger Chinese growth = more demand for commodities. (Chinese demand drove the commodities bull market from 2000-2011).

Here’s what happens next to the Chinese stock market when the Shanghai Index rallies 20%+ over the past 3 months while copper rallies 7%+

China has a slight bearish lean over the next 6 months.
Here’s what happens next to copper

Copper has a bearish lean 1 year later.

Seasonality

April is just around the corner, and it is the U.S. stock market’s most seasonally bullish month, with an average annual return of 2.06%.

Seasonality factors are of tertiary importance. Do not pay too much attention to them, because seasonality often doesn’t play out the way it should.

Who is the “smart money”?

Financial professionals are often called “smart money”, and retail investors/traders are often called “dumb money” (a distinction that I find to be rather arrogant).
Here’s the S&P 500 Total Return Index vs. the HFRI Fund Weighted Composite Index, an index that tracks the performance of 1400 hedge funds net of all fees. As you can see, almost all the outperformance came in the 2000-2002 and 2007-2009 bear markets. From 2009 – present, hedge funds have lagged the S&P badly.


*There is a slight error for the year 1994. Hedge funds outperformed in 1994.
Think about this the next time you think “Hedge Fund Manager XYZ is bullish/bearish, he must know something I don’t, so I should listen to him.”
Read It’s been an epic 3 month turnaround for the stock market. What’s next

Conclusion

Here is our discretionary market outlook:

  1. The U.S. stock market’s long term risk:reward is no longer bullish. In a most optimistic scenario, the bull market probably has 1 year left. Long term risk:reward is more important than trying to predict exact tops and bottoms.
  2. The medium term direction (e.g. next 6-9 months) is mostly mixed, although there is a bullish lean.

Goldman Sachs’ Bull/Bear Indicator demonstrates that risk:reward does favor long term bears.

Our discretionary outlook does not reflect how we trade the markets right now. We trade based on our quantitative trading models. When our discretionary outlook conflicts with our models, we always follow our models.
Members can see exactly how we’re trading the U.S. stock market right now based on our trading models.
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