Risky Business Update----Market Internals Are Flashing

As I’ve said here a few times, there are really only two methods of investing that work – value and momentum. I’d even venture to say that the two are linked in that value informs one about risk while momentum informs one about the willingness of the majority in the markets to assume that risk. Valuation is a very bad timing tool and doesn’t matter all that much until, well, it does and then it matters a lot.  For a bear market, the 2007-2009 downdraft was, believe it or not, rather mild as valuations never reached the low levels they have at the depths of past bear markets. That’s one reason I don’t think the run we’ve had since then is the start of a new secular bull market – the starting point was still at too high a valuation.

The bull market that started in early 2009 had modest valuations and therefore modest risk. If it was the bottom of the secular bear it would have had outright cheap valuations and low risk. But frankly it doesn’t matter. We’ve had a great run off the 2009 lows with a few bumps along the way despite a rather disappointing economic environment. Valuations really started to ramp higher in 2013 as earnings growth slowed and multiples expanded and are now at levels that indicate a rather stunning degree of downside risk. A move back to median valuations – market cap to GDP, price to sales ratio, Shiller P/E, Tobin’s Q – is a long way down from here, at least 50%, and even further to typical bear market lows. But as I said, valuation is a lousy timing tool so the when that happens puzzle will not be solved using whatever valuation technique you choose.

To realize that risk, to see a big drop in the market – a 10 or 20% correction could happen at any time and usually does in bull markets – will probably require a US recession. So, if you are going to be a tactical investor rather than a bury your head in the sand passive investor, you have to find indicators that warn about a recession in advance. I use two indicators – yes only two – as warning signs about recessions. I read all the economic reports and try to glean as much information from them as I can but frankly most of what passes for economic data is mere noise subject to large revisions down the road. The two indicators are the shape of the yield curve and credit spreads. All the research I’ve read says those two methods are the best you can do when it comes to forecasting future economic growth. So, let’s review them and then take a look at what momentum is telling us because the market usually speaks well before the NBER.

The yield curve is pretty easy to interpret. Take a look at the 10/2 year Treasury spread:


As you can see the yield curve in the past has inverted before recession and then steepened quickly as the economy enters recession. The steepening right before and during recession is caused by a rapid drop in short term rates as the economic data deteriorates and the market starts to anticipate Fed rate cuts. The curve will continue to steepen until the Fed rate cutting cycle is over which is usually well past the end of the recession. Of course, we are in a brave new world with rates already at basically zero so things may not work exactly as they have in the past. Certainly the flattening of the curve that one sees after the end of recession – as the economy moves through the business cycle – has not been as smooth in this cycle as the last two. Will the curve go flat before the next recession or will it start to steepen from this higher level? A good question for which no one has a good answer.

In any case, think of the yield curve as a proxy for future nominal economic growth. When the yield curve is flattening, future growth expectations are falling and when it is steepening, future growth expectations are rising. But remember, it isn’t real time. A flat curve does not mean that growth will fall right now and a steep one doesn’t mean growth will pick up right now. Generally think of the lag time as at least 1 quarter and maybe as much as 2 years.

Our other indicator is credit spreads and I’ll show you two ways to look at it. First is the B of A/Merrill Lynch US High Yield Master II option adjusted spread. What we’re measuring here is the difference between the yield of junk bonds and Treasuries corrected for the optionality of the bonds (call features, etc.).

hy master

As you can see, these spreads widen before a recession and generally peak at the trough of the recession. Here’s another way to look at it in relation to the stock market:

credit spread and stocks


It should be fairly obvious why credit spreads should be something an equity investor keeps an eye on. What is concerning is that these spreads have started moving wider again. Here’s a shorter term chart:

hy master 2

For comparison purposes, today’s levels are comparable to late October 2007, about a month before the last market peak. Here’s another easy way to track spreads using ETFs:

ief hyg


This is a ratio chart of IEF (7-10 year Treasury ETF) and HYG (High Yield bond ETF). When the ratio is rising the Treasury ETF is outperforming the high yield ETF. As you can see this ratio bottomed last summer and despite a recent correction is still in a rising trend.

So, recession wise our two indicators are a bit murky. The yield curve has flattened but is not flat but we don’t know if it will get to flat before the next recession. Credit spreads are widening, moving in the wrong direction but not at levels that are recessionary yet. But both indicators are moving the way we would expect at the end of an expansion cycle with the yield curve flattening and credit spreads widening.

So what about momentum? What is the stock market telling us? As I pointed out the other day, momentum is waning and the long term momentum indicators I follow are flashing warning signs:



The momentum indicators are in the two bottom panes. MACD is on a long term sell signal while the Price Momentum Oscillator is, well, oscillating around a sell signal. It would only take a small move down to push PMO into a sell signal as well. I would stress though that these are monthly charts and so this would really only be valid at month end. We’ll see if we get there in the next couple of weeks.

What credit spreads and momentum tell us about is the willingness of investors to take risk. Widening credit spreads mean that bond investors are turning risk averse. It makes sense that bond investors would be the first to turn away from risk with stock investors lagging a bit. Right now, risk aversion is pretty obvious and growing in the bond market while momentum tells us that it is building in the stock market as well. Momentum tends to lead price which is why you should pay attention to it. If you wait for the price signal you will be selling with everyone else who is concentrating on price. Momentum gives you some lead time.

To summarize:

  • The yield curve is flattening indicating that nominal growth expectations are falling. Of note is that past tightening cycles – if that is truly where the Fed is headed – generally started with a steeper curve. I’ve seen numerous articles recently that one shouldn’t worry about the Fed hiking rates because stocks can still go higher after the tightening starts. That is true but less so this time because it probably wouldn’t take much tightening to push the curve to flat. I would also not be very concerned about owning bonds if the Fed starts hiking as the more they do the closer we’ll be to recession when the only thing you’ll want to own is bonds.
  • Credit spreads are widening indicating declining risk tolerance by bond investors.
  • Stock market momentum is waning, the beginning of declining risk tolerance by stock investors.

Investing is a risky business and you need to operate with an understanding of other’s willingness to take it. When bullish sentiment finally peaks in this cycle and people start moving to the bear camp it will be too late to avoid what I expect to be a nasty drawdown. Pay attention to the leading indicators of risk tolerance and beat the rush. Right now they are telling you to dial back the risk portion of your portfolio. Are you listening?

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