What is the message of the markets?
The Primary Stock Market Trend
In my last market update report in March, “SPY: The death cross and what you need to know,” I laid out the case for a primary downtrend being in force for the S&P 500 and the broader US stock market. Since this time, market prices have confirmed the primary downtrend by falling for seven consecutive weeks. The question now is where do we go from here?
Technical Backdrop: S&P 500
The S&P 500 is unique amongst the major US stock market averages in that it has carved out a head and shoulders top pattern in addition to forming a death cross. Please keep in mind that there is nothing magical about a death cross, as discussed in the prior report, or a head and shoulders formation for that matter. That said, when used in conjunction with the macro environment, corporate fundamentals, and economic trends, technical analysis provides essential context for understanding price trends.
For example, when buying a house, everyone studies historical pricing trends, volumes, and price comps (technicals). While the fundamentals of location, neighborhood, school district, crime, local government, climate, etc. are the primary considerations underlying a home purchase, the price trends provide indispensable context for the ultimate decision. This is the essence of technical analysis.
The following quote and 5-year weekly chart from my March market update set the stage for understanding the path that we are on.
Notice that the short, upward-sloping orange line, which represents the neckline of a potential weekly head and shoulders top, is more easily visible and aligns quite well with the monthly closing prices. This level is currently being tested from underneath…
In late March, as can be seen in the above chart, the S&P 500 index (NYSE:SPY) was testing its two primary resistance levels denoted by the orange lines. The diagonal orange line is the head and shoulders neckline, and the horizontal line is broken support from the topping pattern in late 2021.
The next chart carries over the same resistance and support levels (the green and blue lines) and updates the price action since. I have used a 3-year weekly chart instead of a 5-year chart for a closer look at the action.
Notice that the S&P 500 was rejected precisely at the upper orange line. This occurred the week following the March market update with the peak occurring two days after the report. The market then went on a seven-week losing streak, the first such streak since 2002. Please notice that I have added a third orange resistance line (the lowest orange line) as the 7-week decline took out a prior support level which has now become additional resistance.
In summary, the market has provided confirmation that we are in a primary downtrend of unknown length and depth. I will turn to the key fundamentals shortly to explore the question of the most likely length and depth of the downtrend. The following 2-year daily chart provides a closer look at the current setup.
Notice that the current price of $412 is only 2% beneath the new resistance level at $420. Additionally, the gold line represents the 50-day moving average which is also in this zone at $421. This area should be a challenging resistance level against the fundamental backdrop of declining economic growth, earnings disappointments, elevated inflation, and rising interest rates. As we will see, this is especially the case as the S&P 500 is materially underweight sectors that benefit from these fundamental trends.
The nearest primary support zone is designated by the two green lines which represent a price range of $338 to $351 compared to the current price of $412. The downside potential to this support zone is -15% to -18%. With the market currently down only -14% from the all-time high in January, a test of this primary support zone remains highly probable within the context of a typical bear market correction. If this occurs, the decline from the peak would be in the range of -27% to -30%.
The lower blue lines represent a primary resistance zone dating from 2018 to 2020 which should prove to be an exceptionally strong support level. If this lower zone is tested, the downside from current levels would be -27% to -30%. The downside from the peak would be -37% to -40%. A potential decline of this magnitude from the peak cannot be ruled out as evidenced by the two prior bear markets which saw declines in the -50% range. The fundamental backdrop will shed light on the most likely path forward.
To understand the fundamentals underlying the S&P 500 index, one must first understand the sector weightings in the index. Doing so places into context my comment that the S&P 500 is likely to struggle at key resistance levels given fundamental trends. The following table breaks down the sector weightings in the S&P 500. It is from my Rio Tinto (NYSE:RIO) report last week, “Rio Tinto is a perfect portfolio diversifier,” in which I covered the diversification weakness within the S&P 500.
I have highlighted in yellow those sectors that benefit the most from existing economic trends. These two sectors account for just 8% of the S&P 500, which is a largely immaterial weighting. As a result, the S&P 500 has marginal exposure to the sectors that are best positioned for the current market climate.
The current economic trend features slower growth, elevated inflation, higher interest rates, and the removal of massive quantities of fiscal and monetary stimulus. These factors represent a distinct challenge for the following sectors: information technology, consumer discretionary, and consumer services. These sectors account for 47% of the S&P 500, or nearly half.
Turning to the other sectors, real estate should be pressured by higher rates on the valuation front and by the economically sensitive subsectors. Utilities are trading in the range of 30x earnings, which appears extreme. This is especially true in light of the rising rate environment. Consumer staples are being hurt by cost inflation, though sales are likely to be more stable than most. Healthcare should hold up well.
Finally, financials and industrials could be challenged in this environment as they often have been historically. There are competing forces that are unique to the current cycle that add support to the two sectors. Large US financials are financially strong and higher rates could increase margins. Industrials should be supported by policy trends such as the energy transition, onshoring, and the expansion of regional supply chains in addition to the positive trends in the energy and materials sectors.
All told, the trends in place are distinctly negative for 52% of the index while being historically negative for 19% more, though there are some offsetting effects for this group. Those industries that are experiencing neutral trends account for 21%, while those experiencing positive trends account for just 8% of the S&P 500. At minimum, with only 8% of the portfolio experiencing positive trends, the path forward is likely to remain volatile. For more color on the likely path for the other 92%, we need to discern what is priced into the market.
With economic trends skewing negative for roughly 70% of the S&P 500, the question turns to valuations. As mentioned above, the utility sector is trading at over 30x earnings as can be seen in the following table compiled from The Wall Street Journal. I have highlighted in yellow those stock market indices that are trading at historically elevated valuations. The S&P 500 index is highlighted in blue.
With a trailing PE of 22x, the S&P 500 is certainly not extremely valued compared to the other market indices. That said, the S&P 500 shares many of its largest holdings with the Nasdaq 100 index. As a result, further valuation corrections within the Nasdaq would weigh heavily on the S&P 500.
Additionally, a mid to high teen valuation is more in line with historical norms for the broad stock market. If earnings growth comes under further pressure, valuation compression is highly likely. Furthermore, if we are past peak earnings and profit margins for the current cycle, the valuation multiple compression will coincide with declining earnings, which is the worst-case scenario for stocks.
I covered the Nasdaq 100 (NYSE:QQQ) and the Russell 2000 (NYSE:IWM) in the March update. They too have progressed similarly to the S&P 500. Given that all stock indices are positively correlated, a quick review of these two major indices is relevant to the S&P 500 and will shed more light on the situation.
For this task, a picture is worth a thousand words. In the charts below, I compare the 1-year chart from March with the current 1-year chart for both the Nasdaq 100 and Russell 2000 indices. The progression of the Nasdaq 100 technical backdrop is identical to that of the S&P 500. Please note that the rally attempt at the time of the last report (the first chart below) was rejected just above the orange resistance line at the 200-day moving average (the grey line). Additionally, note that the recent bounce in the Nasdaq 100 (the second chart) occurred at the second primary support level (the lower green line).
March 24, 2022: Rally attempt off a potential double bottom
June 8, 2022: Failed rally and a test of next support level
While a further rally attempt back toward the upper green line is possible in the short term, the index remains in a solid downtrend. The downtrend is occurring against a backdrop of elevated valuations and negative economic trends which are pressuring both the price and the earnings side of valuations (P/E).
The Russell 2000 is in a similar technical boat. It too was rejected at the nearest resistance level following the rally attempt at the time of the March report. Interestingly, like the Nasdaq 100, the recent bounce in the Russell 2000 (the second chart) occurred at the first major support level (the green line). Notably, the S&P 500 has yet to test its first major support level.
March 24, 2022: Rally attempt off a potential triple bottom
June 8, 2022: Failed rally and a test of next support level
In summary, the S&P 500 and the broader US stock market are unequivocally in a primary downtrend. The technical behavior of each index is precisely what one would expect in a bear market. The remaining question is what is the most likely pathway forward?
Interest Rates: How We Got Here
To know where we’re going, we have to know where we’ve been. The following chart of the 10-year treasury bond yield courtesy of the St. Louis Federal Reserve is the single best picture for capturing where we’ve been.
A 40-year trip through ever lower interest rates. Notice the final plunge in the lower right-hand corner, coincident with the onset of the COVID pandemic. This took the 10-year treasury yield to a bottom of roughly 0.5% from a peak near 16% in September 1981.
With bonds and interest rates at the heart of the financial system and fundamental to all valuations, declining interest rates have been a driving force behind asset price inflation in recent years and since the early 1980s. Whether or not the secular trend in interest rates has reversed is therefore of central importance in determining the most likely path forward.
The Yield Curve
To answer the question of whether or not the recent rate spike represents a secular trend change, we must first start with the current upcycle. Is the current upcycle behaving unusually or is it in character with the behavior of rates during past spike episodes during the 40-year downtrend?
The bond market speaks through the yield curve. In other words, the market speaks to economic conditions and expectations by its differential pricing of short-term versus long-term rates. As a result, to answer the above questions, I will explore the behavior of the yield curve in the current cycle compared to historical cycles.
In the following chart from the St. Louis Federal Reserve, I have displayed the treasury yield curve since 1976. I have chosen to use the difference between the 2-year yield and the 10-year yield to define the yield curve through time as it is a widely accepted curve benchmark.
At first glance, it is clear that the bond market, or yield curve, has experienced several well-defined epochs since 1976. Given recent concerns about a possible yield curve inversion and it signaling a possible recession, this study takes on added importance. Notice in the lower right-hand corner of the chart that the yield curve briefly inverted in April 2022. Note that going beneath the black horizontal line indicates an inverted yield curve (2-year yield > 10-year yield).
Unusual behavior in the bond market is immediately evident. The recent spike higher (steepening of the curve) from January 2020 into April 2021, was extraordinarily short lived. Additionally, the spread peaked out well below prior epochs. The unusual behavior in the current cycle hints at a change of character in the bond market when viewed through the lens of history.
Yield Curve Epochs
Reviewing each bond market epoch since 1976 will shed light on what is different this time. The following tables were compiled from the underlying data depicted in the St. Louis Federal Reserve chart above. I defined the time frame of each epoch to be the onset of yield curve inversion until the curve reestablished 25 basis points of positive slope (the 10-year minus the 2-year gets back to +0.25%).
This is the typical increment by which the Federal Reserve moves short-term interest rates and serves as a logical demarcation of an inverted/flat curve regaining upward slope. Please note that I have color coded the key data points in each epoch for ease of comparison across cycles. Furthermore, I have grouped the epochs into three subsets in order to illuminate the trend.
The two epochs in the above table represent the longest duration inversion cycles. Of note, they are also the first two epochs during the secular rate downtrend. They each had similar beginning and ending long-term interest rates, with the 1978-1982 period featuring extraordinary yield curve volatility. This volatility is clearly visible in the yield curve chart above.
Please note that I consider 1978 to 1982 to be one epoch even though there were brief moments in which the yield curve was not inverted during the period. 25 basis points of upward slope was not sustainably reestablished until 1982, following back-to-back recessions. The 1978-1982 period was exceptionally long at 42 months as the federal reserve was reversing the structural inflationary trend of the 1970s.
This epoch marked the last secular interest rate transition, from rising rates to falling rates. That period featured both an unusual inversion duration and unusual yield curve volatility, which would be likely signals of major regime changes in the bond market. In the case of the last secular shift, the inversion duration was unusually long, and yield curve volatility was unusually high.
A trend that will become visible as we go through time is the shortening of the inversion cycle (the yellow highlighted cells) as the 40-year bond bull market progressed.
The 1997 to 2000 epoch featured two inversion cycles with the second coinciding with a recession. Of note, four of the seven inversion epochs since 1976 coincided with recessions. Yield curve inversions are not necessarily a predictor of recessions, but they are a red flag for the heightened risk of one. The 2018 to 2020 and 2022 epochs were exceptionally swift and extreme outliers as can be seen in the following table.
The duration of the two most recent epochs is clearly out of character compared to the preceding five cycles. If you blinked, you might have missed the 2022 epoch in its entirety as the yield curve inverted for only two days and regained upward slope within a mere two weeks. Time will tell if the 2022 epoch is an initial tremor or merely a blip on the screen. The following quote from the last market update captures the essence of the current situation.
While risk-free rates may become periodically kinked at points along the yield curve, global central banks appear to have the ability and resources to maintain upward sloping yields. This is especially the case given the extreme inflationary backdrop.
In addition to the unusually short duration of recent inversions, interest rate volatility has been extreme. Long-term rates bottomed during the 2018 to 2020 epoch at an extraordinarily low yield near 0.5% (50 basis points); currently they are near 3% (300 basis points). This speaks to the other signal of a regime shift, volatility.
A 250-basis point increase in rates from a starting level of 50 basis points represents an exceptional level of rate volatility. Meaning, a 250-basis point change from a starting rate level of 450 to 1100 basis points is much different than starting at 50. For perspective, the percentage change from 50 to 300 is 500% compared to 55% and 14% from a starting point of 450 and 1100 basis points, respectively.
Yield Curve: A Summary
The current epoch displays all the signs of a major inflection point and trend change for rates. It features unusual inversion duration and unusual volatility.
On the volatility side, the difference in the current epoch compared to the 1978 to 1982 inflection point lies in what is unusual and what is volatile. During the 1978 to 1982 period, the volatility expressed itself through yield curve volatility.
In the current epoch, volatility is expressing itself through relative yield changes. For example, the 2-year yield was under 25 basis points as recently as September 2021. The move higher to 280 basis points occurred with historic speed and thus, volatility. To date, the yield curve in the current cycle has experienced unusually low volatility.
For greater color on the current cycle, the table below compares the average slope of the yield curve in basis points since 1976 to the slope since 2020 (the most recent epoch). I have highlighted in yellow the difference in the median yield curve slope in the current period (2020 onward) compared to the entire 40-year period.
Notice that the slope of the yield curve in the current epoch, in basis points, is nearly identical to the average since 1976. As a result, the slope of the yield curve in the current cycle is quite normal. This is especially the case considering the extraordinarily low level of long-term interest rates in the current cycle; the 10-year yield reached an incredibly low 0.5% in 2020.
Given that long-term interest rates remain quite low from a historical perspective, as well as in relation to inflation trends, there is ample room for the current yield curve to rise and steepen from here.
Interest Rates: Current Trends
Since the bottom in 2020, interest rates have exploded with all signs pointing to a major trend reversal to the upside. The current rate trend across the broad bond market remains solidly upward. In the following table, compiled from The Wall Street Journal and my March report, I compare current government-linked yields to the same yields as of the March update. The yield changes in basis points are in the right-hand column. The bond data providers include Bloomberg, J.P. Morgan, and ICE Data Services.
I have highlighted in yellow what I view to be the best gauge of the risk-free interest rate trend since the March report. Rates on the intermediate to long-end of the curve have increased by 60 basis points (0.6%). This provides a foundation for gauging the message of the bond market when it comes to the state of the economy.
Corporate Bonds: The Economic Signal
While risk-free government bonds provide pure interest rate trend information, the corporate bond market provides economic trend information.
Knowing that risk-free rates have expanded by 60 basis points since the last market update, we can place the change in corporate bond rates into an economic context. The following table was compiled from The Wall Street Journal and my prior report. I compare current corporate yields to the same yields as of the March update. The yield changes in basis points are in the right-hand column. I have highlighted the cells that capture the economic signals from the bond market since March.
I have highlighted in yellow the investment grade bond market signal. Notice that the yield increase is roughly 60 basis points as was the case for the risk-free bond market in the previous table. The bond market is not signaling material economic trouble for quality corporations.
The signal from the lower-quality end of the corporate bond market is decidedly negative. Notice that rates on triple-C rated bonds exploded to the upside by 266 basis points. This is roughly 200 basis points of yield spread widening compared to risk-free interest rates (highlighted in blue). These bonds represent a canary in the economic coal mine given their sensitivity to changes in economic conditions.
The broader junk bond market (the lower section of the table) is behaving much better than the triple-C rated index. Here, using the European high yield market as a benchmark, rates expanded by 120 basis points. This is a spread widening over risk-free rates of roughly 60 basis points. The spread widening of 60 basis points compared to risk-free rates is likely signaling a normalization of absolute junk bond yields as well as increasing economic risks.
The junk bond market is certainly not signaling impending economic doom, rather, it is signaling an economic slowdown and a renormalization of rates. Additionally, current junk bond yields are in the 5.5% to 7.5% range which, historically speaking, is moderate. Similar to the risk-free and high-quality segments of the bond market, there is ample room for rates to continue higher.
The Current Yield Curve
The global risk-free yield curves are summarized in the table below compiled from Bloomberg. Notice that all five yield curves are upward sloping and that the spread between the 2-year and 10-year yields are within the margin of error, historically speaking.
Risk-free yield curves are not signaling an impending recession. That being said, economic volatility is highly likely and could feature a technical recession. The supply chain chaos created by the COVID shutdowns in concert with excess demand amplified by fiscal and monetary policies is being unwound.
As these forces continue to reverberate through the global economy, both risk and opportunity will remain elevated. The Chinese call it yin and yang. While the structural shifts afoot will produce headwinds for the broad market over the near term, the process is advanced. This has created an opportunity-rich environment for those that are selective, as the path forward will be a reflection of where we have been.