Economic Head Fake
Bond Yield and Commodity Breakout Fails
In last month’s newsletter, I highlighted two main points. One, the market was in an uptrend; however, overbought and due for some type of pullback/correction. Two, commodities and treasury yields were starting to breakout. Economically sensitive commodities such as copper and oil can be viewed as a proxy for the global economy. Seeing them start to rise after falling for an extended period was bullish for the economy/stock market. An upturn in both bond yields and commodities would be a strong signal of renewed global growth.
These bullish market developments didn’t last long, however. Both commodities and bond yields broke-down last month proving those advances to be simply head fakes.
Numerous additional warning signs have popped up over the past month that suggests market risk has risen. The most important ones are:
1. A drop below important trend-lines in commodities and treasury yields.
2. Another inversion of the yield curve.
3. Out-performance by risk-off assets such as gold, utilities, REIT’s, and treasury bonds.
4. The S&P 500 has fallen below an up-trending channel that has defined its advance since early October 2019.
Below are some charts that highlight these developments.
Below is a daily chart of the S&P 500 going back 9 months. Here are the things to notice about the chart:
1. The index has fallen below the lower end of the channel signaling a possible change in trend.
2. The index has fallen below a previous low (support).
3. The index is above it’s 50-day moving average which could provide some support if the index falls from here.
4. The PPO (momentum indicator) in the lower panel has rolled over.
When investors feel confident that the economy is growing and thus stocks should rise, they buy commodities as well as other risk-on assets. They tend to favor riskier stocks over the safety of treasury bonds which pushes yields higher due to a lack of demand for bonds.
After months of continued weakness in commodities and bond yields, both broke out to the upside, hinting that we were starting to see signs of economic growth and a reflation trade. That advance has failed as I have illustrated in the charts below.
In the chart below, I have the S&P 500 in the top panel, the relative strength of copper versus gold in the next, the 10-year treasury yield next, and crude oil in the bottom panel.
In green text I have noted where each broke-out to the upside. Those positive signs didn’t last long in that each broke-down below their respective uptrend lines, as I have noted in red text.
The recent breakdown in these charts is a strong bearish warning for equity markets. Or at the very least suggesting that we should favor risk-off assets in our investment portfolios.
Longer-term bond yields are typically higher than shorter-term bond yields and when they are not, it is viewed as an early warning sign of an impending recession. These inversions are rare but historically have been very accurate in predicting an economic downturn.
Below is a chart of the 10-year treasury yield (brown line) and 3-month treasury yield (pink line) in the upper panel. In the lower panel is the S&P 500 Index going back over 20 years.
I have noted, with vertical red lines, occurrences where those yields have inverted. Notice the first inversion in April of last year and again last Friday.
Each of the two previous economic recessions was preceded by an inversion and a severe stock market correction that saw stocks fall approximately 50%.
As noted in last month’s newsletter, gold has formed a long-term base and recently broke out of a bullish wedge pattern as I have noted with green text. Gold still looks bullish to me and has the added benefit of frequently being a good stock market hedge.
Below is a chart of TLT (20+ Treasury Bond Fund) and it too has broken out of a bullish wedge pattern.
Utilities are in a strong uptrend.
REIT’s have broken out of a wedge pattern too and are in a long-term uptrend.
The initial signs of a pickup in economic growth look to have been short-lived. The breakdown in commodities and bond yields coupled with out-performance by risk-off assets is suggesting that economic weakness is likely to negatively impact stock prices in the near term. This combined with a breakdown in the S&P 500 Index (last week) on high volume and very negative breadth further confirm this hypothesis.
Understanding risk is important because markets can fall a lot faster than they rise.
Client Account Update
Over the past couple of months, we have strategically added equity positions. Client accounts have about 40% allocated to equities, however, we are heavily invested in more defensive asset classes such as gold, utilities, and REIT’s.
The remaining amount is allocated in interest-rate sensitive bonds and cash.
I will continue to reallocate our client accounts strategically based upon our analysis of the markets.
Now is the time to reevaluate your retirement account allocations, not later after you have incurred substantial losses.
If you are worried about how your retirement accounts are allocated, shoot me an email and we can schedule a virtual meeting to review your holdings and investment strategy.
Craig Thompson, ChFC
Asset Solutions Advisory Services, Inc. is a Fee-Only Registered Investment Advisor specializing in helping the needs of retirees, those nearing retirement, and other investors with similar investment goals.
We are an “active” money manager that looks to generate steady long-term returns, while protecting clients from large losses during major market corrections.
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