What the US Treasury Yield Curve is Telling Us

December 11, 2017

To nobody’s surprise, the S&P500 continued to melt up. Last week it climbed another 0.35%. Volume was light. And volatility was almost non-existent: the VIX index closed back down below 10, which historically has rarely been reached.

The technical picture remains unchanged from last week—the S&P500 is a market that’s extremely over-stretched on the daily and weekly resolutions. Last week’s modest advance in the index did nothing to change this condition.

In US macro news, most of the reports were disappointing. International trade missed. PMI services and ISM services also both missed. Productivity came in lower than expected; as a result, unit labor costs rose more than expected. consumer sentiment disappointed. Wholesale trade missed badly. And in the US payrolls report for November, the average hourly earnings were lighter than predicted. On the positive side, factory orders fell less than predicted. Consumer credit grew more than expected. And in the payrolls report, more jobs were created, and the average workweek was slightly longer than expected.

Recently, market analysts have spotted an interesting development in the US yield curve. While the curve is still positively sloping (ie. the 10 year Treasury is yielding more than the 2 year UST), the difference between these two maturities has been collapsing over the last couple of years. This is important because in almost all of the most recent market and economic slowdowns, something similar has also happened…but well before these slowdowns actually hit. Specifically, the 2 year and 10 year have always inverted; that means that the 2 year yield exceeded the 10 year yield, creating a downward sloping yield curve.

Even more interesting was the timing of this development. The most recent two yield curve inversions preceded the subsequent market and economic retreats by about 18-24 months. So while today’s curve is only approaching inversion, when it finally arrives (and the Fed’s rate hikes have been the key driver of the recent curve flattening) when the Fed raises short-term rates several times over the next 12 months, history shows that a market slowdown is almost sure to follow….but only 18 to 24 months after the inversion first appears.

So is the yield curve telling us that the bull market in US risk assets has another two years to go?


US Stock Market Psychology is at Extreme Highs

December 4, 2017

Incredibly, the S&P500 rose again last week. This time it jumped by about 1.5%. Volume was very light….so no huge surge in investor conviction. And counter-intuitively, S&P VIX also jumped, suggesting that while the retail masses are comfortable owning stocks….and even buying a lot more….some more sophisticated investors and traders are buying downside insurance.

Was there some sort of surprising economic news to power the S&P forward last week? Nope, not at all. In fact, the last week’s reports were filled with disappointments. The Dallas Fed manufacturing survey missed, for example. But there’s much more—international trade in goods, the FHFA house price index, wholesale inventories, PMI manufacturing, and the ISM manufacturing index all disappointed versus expectations. On the positive side, new home sales, consumer confidence, pending home sales, personal income, and Chicago PMI and construction spending all beat expectations. So the bottom line is that the US economy has not suddenly improved, which could explain last week’s surge in US stocks.

Technical analysis is showing a US stock market that’s almost disturbingly overstretched to the upside. On both the daily and weekly charts, prices are literally moving off the charts…to the upside.

Meanwhile, valuations have now approached the two most overvalued levels in US history—the period just before the 1929 peak, and the period just before the 2000 peak. In both cases, crashes—massive crashes—ensued. But in the period leading up to those crashes investors were largely euphoric….and still heavily long US stocks.

And this same phenomenon is now occurring today. Specifically, investor psychology is now so bullish, that virtually all negative news can spark any meaningful selling in US stocks. On the contrary, any small “dips” are immediately bought, often within hours of the dips occurring. And keep in mind that some significant, and normally bearish, news has been released over the last several months. In geopolitics, North Korea is now literally capable of hitting the US mainland with a nuclear weapon. In terms of monetary policy, the Fed has not only already started raising interest rates and reducing its balance sheet, but it’s communicated that this policy will continue for at least another year. And the US yield curve is flattening and soon possibly inverting, a condition which almost always precedes not only a US economic recession, but also a major market correction.

But today, in US equity markets, nothing negative seems to matter, except one thing—the absolute conviction by investors that stocks will continue to go up, despite all the risks outlined above, and that the only rational thing to do is to continue to own them….and to buy them.

Some day this will change; it always does. But until then, it’s not worth fighting the trend, which is still–clearly–bullish. And when this trend, and market psychology, finally reverses, it’s especially important to remember that almost everyone who’s currently long will get hurt. It will be impossible for the average investor….and even for most pros….to get out before the drop has severely taken away a big chunk of their current paper profits.


Gold Continues to Form Bullish Pattern

November 27, 2017

The S&P500 bounced back after two consecutive weekly losses. Last week, the large cap index gained about 0.9%, and in the process, it set new all-time highs. Volume was very light, but that had more to do with the Thanksgiving holiday than with investor sentiment. Meanwhile, super low complacency returned to the S&P—the VIX index fell back not just to levels  below 10, but it dipped below 9. Needless to say, this is extremely low, by historical standards.

In US economic news, the reports were mixed. Leading indicators and the Chicago Fed national activity index both beat their respective consensus estimates. On the other hand, durable goods orders missed—both headline and core results disappointed. Also, PMI composite flash missed expectations. This week, with no holiday interruptions, a much larger and more normal number of reports will be released.

In terms of technical analysis, the S&P500 is once again stretched—seemingly—to the upper reaches of normal pricing levels. On both the daily and the weekly charts, last Friday’s closing price pushed the index back up to the upper Bollinger Bands.  Prices are also clearly above the 50 day and 200 day moving averages, which themselves are comfortably sloping upwards. So if it weren’t for the fact that valuations are now stretched to the upper 5% – 10% of most major measures, then the obvious conclusion one should draw from the technicals is that the bull market is in effect and that the average investor should maximize his or her allocation to US equities. But since valuations are also so obscenely high, again according to long-term historical measures, the average investor should instead be extremely cautious about being overly invested in US equities, because with these current conditions, any sort of pullback could become more severe than usual.

Finally, the bullish pattern that gold began to form in 2016 (after suffering from a bearish pattern since 2012) appears to be strengthening. After bottoming at the end of 2015, gold has essentially been tracing out a new uptrend. The lows reached after the lowest low of 2015, have been higher than this low of 2015. The 200 day moving average is now sloping upwards. The 50 day has crossed above the 200 day (“golden cross”. All that remains for this apparent bullish pattern to be fully confirmed is for prices to rise above the highs reached in 2016; this would confirm an inverted head and shoulders formation—a strongly bullish signal—especially when seen on longer term resolutions such as the weekly charts.

So the big test for gold will be roughly $1,375. If this price is reached and if it sticks, then pretty much all the major barriers to much higher prices will have been removed. After $1,375, gold’s next targets would be$1,550 and after that the upper $1,700’s where many of the late-comers to the prior bull run bought gold and would now consider selling because they’ve returned to break even.


S&P500—Pausing or Reversing?

November 20, 2017

For the first time in many months, the S&P500 lost ground two weeks in a row. While the prior week’s loss was 0.2%, last week’s loss was also tiny—down only 0.13%. Volume was very light, so there was no real conviction behind the selling. And volatility didn’t change much: the VIX index remained just above the record lows reached earlier this summer and fall.

Last week’s US macro results were mostly negative. Producer prices, both headline and core, came in hotter than expected; this puts pressure on corporate earnings in the near future. Retail sales were mixed: while headline sales were slightly stronger than expected, the core (excluding autos) sales figure was weaker than expected. The Empire State manufacturing survey came in well below expectations. Business inventories missed. Initial jobless claims were much worse than predicted. The Philly Fed business outlook survey missed. And so did the Kansas City Fed manufacturing index. Only industrial production and housing starts beat expectations.

In terms of technical analysis, the two small consecutive weekly losses on the S&P500 have not really changed the outlook on the weekly charts. These two losses are barely visible. So from a weekly chart perspective, the picture is still bullish. Sure prices are totally stretched to the upside and are ripe for a multi-week pullback, but the actual pullback cannot be called with a lot of confidence. If anything, the recent pullback looks like only a pause in a longer-term upward move.

On the daily charts, however, the recent pullbacks have changed the outlook. Today, there’s a more clear indication that prices may be heading downward, at least in the short-term. MACD and RSI for example are rapidly diverging downward, suggesting that there may be some more short-term selling in the near term. So at least according to the daily charts, look for some sort of near term pullback in the S&P.


High Yield Prices are Sagging

November 13, 2017

For the first time in many weeks, the S&P500 lost some ground. That said, the loss was tiny—only a 0.2% drop. So despite the headlines about stocks retreating, prices remain very close to all-time highs. Volatility did inch up, as would  be expected in a week when prices fell. But the VIX index remains near the low end of its multi-year range; in other words, traders and investors remain complacent and if anything continue to sell volatility betting that it will not rise measurably anytime soon. Volume on the S&P was a bit higher that usual over the last four weeks, but it remains on the low end of longer term ranges. Here too, there were no signs of any type of panic selling.

In US macro news, the week was fairly quiet. While consumer credit rose a bit more than expected, job openings (in the JOLTS survey) and wholesale trade only met expectations. On the downside, initial jobless claims and consumer sentiment were both weaker than economists had predicted. So not a lot of new information was reported last week, but the few results that did come out did nothing to change the fact that the US economy is still limping along in slow-growth mode.

There were several interesting developments, however, on the technical analysis front.  First, the upward momentum in prices, especially when viewed on the daily charts, has slowed considerably. In fact the MACD indicator (on the dailies) has turned bearish—the fast line has crossed below the slow line and both lines are sloping downward. This is still not a huge turn downwards, but it’s something to pay attention to when prices remain near record highs.

Another interesting development is the deterioration in market breadth. The advance-decline line, for example, has not only taken a big dive down, but it’s turned negative. In other words, many more stocks are declining than advancing….over the last week.

Finally, cross market indicators have also taken a bearish turn. High yield bonds, for example, have started to deteriorate far more than the overall S&P500 price. This can be seen on the HYG ETF or on the Merrill Lynch high yield option adjusted spread.  And since high yield bonds are considered to be risk assets, similar to equities, these two asset classes tend to be fairly well correlated. So when high yield falls in price, there’s a good chance that stocks will tend to follow high yield prices, in this case, downward.

So while there are no super loud alarm bells ringing, several quieter but still very important alerts have gone off—US stock investors, almost all of whom are completely bullish these days, should pay attention to these signals.


What does Price-to-Sales tell us about the S&P 500?

November 6, 2017

Another week, and another super tiny close higher on the S&P500. It’s as if the US stock market, pretty much no matter what bad news hits, will tend to grind higher….even if only by a small percent. Last week, this gain was 0.26%. Volume was very light, and volatility was also low and dropping, as investors look to pad their incomes by continuing to sell volatility betting that it will simply never jump higher.

The technical picture has not changed much. If anything, it’s even more distorted—to the upside—than it was the prior week. Prices on both the daily and weekly charts continue to push up against, or even cross above, their respective upper Bollinger bands. To say that prices are overstretched, even on a short-term basis, is an understatement.

With respect to US economic data, the big report of the week was October payrolls, which missed by over 60,000 jobs. While the headline unemployment rate looked good (only 4.1%) that happened as a result of almost a million people leaving the labor force; as a result, they’re no longer counted as being unemployed, even though they have no jobs. In acknowledgement of this development, the labor force participation rate dropped from 63.1% to 62.7% which is a big drop in only one month. Also disturbing in the jobs report was the fact that average hourly earnings did not grow at all; they were projected to grow by 0.2%.

In other economic news, personal income only met expectations; but personal spending did beat slightly. Chicago PMI and consumer confidence also beat their respective consensus estimates. Construction spending and productivity also recorded beats. ISM manufacturing, on the other hand, disappointed, as did the Case-Shiller home price index when measured on a year-over-year basis.

Finally, veteran investment manager John Hussman—in his recent market commentary—carefully re-examined current US stock market valuation levels and one of his most interesting observations focused on the price-to-sales ratio . And specifically, he pointed to MEDIAN price-to-sales because without using the median, it’s very possible that a small group of very large and high-priced companies could make the entire S&P500 looked overvalued.

In fact, as Hussman notes, this is exactly what happened in the 2000 bubble when the overvaluation in the S&P was concentrated in the high-tech sector, when many other sectors were not very over-valued.

Today, the median price-to-sales ratio of the S&P components is about 50% above the 2000 extreme!  It’s also very well above the 2007 highs.

The conclusion he draws is two-fold. First, prices in the S&P500 are extremely overvalued, based not only long-term history, but even by comparison to the 2000 tech bubble. Second, in today’s bubble, there are no relatively safe sectors, like there were in the 2000 bubble where most of the extreme overvaluation was concentrated in the tech sector. Today, most every sector in the US stock market is extremely over-valued.

S&P 500 Still at All-Time Highs

October 30, 2017

Despite some notable daily sell-offs, the S&P500 rallied at the end of the week, not only to erase all the earlier losses but also to finish the week higher than it did the previous week!  While very small (only 0.2%), a gain is a gain, and the large cap index managed to close near another record high. Volume was modest and volatility, which did jump during the daily sell-offs, managed to slide back down to the super low levels it’s been enjoying for many months now. All in all, last week’s intra-week dip looks like it was nothing more than a false alarm.

Everyone seems to be returning to the two major themes that have worked for several years now—buy the dip in stocks and sell volatility to generate even more income. The music is still playing, so everyone is still dancing!

With respect to technical analysis, the S&P500 is back to being as over-stretched as it’s ever been in the recent past. On both the daily and weekly resolutions, the index is pushing through the upper Bollinger bands and therefore deviating from the 50 day moving average by a huge margin. For example, a simple reversion back to the 50 day moving average would mean the index wold have to lose about 2.5%. More importantly, a perfectly normal reversion to the 200 day moving average would mean that the price would have to drop over 6%….something most long-only investors are not expecting to happen anytime soon, especially those investors who are selling volatility, because they would get crushed if the index ever lost anywhere close to 6%.

In terms of US economic news, the results were mixed last week. The Chicago Fed national activity index beat expectations, and so did PMI composite flash. Durable goods orders beat consensus estimates, as did new home sales. On the negative side of the ledger, the Richmond Fed manufacturing survey missed. So did international trade in goods, as well as pending home sales and consumer sentiment. Once again, the US economy is still stuck in a slow-growth mode.

So as the party in the US stock market continues to rage on, defying almost all historically-informed measures that suggest it’s outrageously over-valued, most investors continue to believe that they have no choice but to continue to attend this party……because there is no good alternative to stocks……and because when, or if, the party ever ends, they believe they’ll have plenty of time to get out before any crash really hits them.