How Stocks Can Go Up When We’re Headed Towards a Recession

This is a Guest Post by Troy Bombardia of BullMarkets.co.

Market outlook: how can stocks go up when we’re headed towards a recession?

The common assumption is that bonds are screaming RECESSION right now, while the stock market refuses to hear it. This isn’t entirely true. While the stock market’s long term risk:reward is certainly not bullish, the economic data suggests that a U.S. recession is not imminent.

Various technical factors also suggest that the medium term is still bullish.

And lastly, the biggest short term risk is still trade war news. If this week demonstrated anything, it is that you cannot trade by guessing the news. Focus on the data & facts.

  1. Long term risk:reward doesn’t favor bulls
  2. Technicals (medium term): mostly bullish
  3. U.S. macro: no significant deterioration, although there are pockets of weakness.

How Stocks Can Go Up When We’re Headed Towards a Recession

Long Term Risk:reward

The stock market’s long term risk:reward favors bears.

Valuations

Everyone knows that valuations are high. Here’s the Shiller P/E ratio, a popular valuation indicator.

How Stocks Can Go Up When We’re Headed Towards a Recession

But while valuations give you a sense of how well the stock market will perform over the next 10 years, it tells you very little about what the stock market will do next month, next year, or even the next 2 years.

How Stocks Can Go Up When We’re Headed Towards a Recession

All valuations can tell us right now is that the stock market’s returns over the next 10 years won’t be as good as the past 10 years.

Yield curve

A lot of attention has been paid to the yield curve recently. But what’s surprising is that while the 10 year – 3 month yield curve has inverted, the 10 year – 2 year yield curve has not.

How Stocks Can Go Up When We’re Headed Towards a Recession

How Stocks Can Go Up When We’re Headed Towards a Recession

This is abnormal, because the 10 year – 2 year yield curve tends to invert BEFORE the 10 year – 3 month yield curve.

How Stocks Can Go Up When We’re Headed Towards a Recession

Here’s every single date on which the 10 year – 3 month yield curve was below -0.2%, but the 10 year – 2 year yield curve wasn’t inverted (plotted onto a S&P chart).

How Stocks Can Go Up When We’re Headed Towards a Recession

The signal dates come in 3 clusters:

  1. July 20, 1989 – August 8, 1989
  2. December 27, 2000 – January 9, 2001
  3. March 21, 2007 – May 1, 2007
  4. Now (May 31, 2019 – June 7, 2019)

Let’s look at the individual cases. Here’s 1989:

How Stocks Can Go Up When We’re Headed Towards a Recession

Here’s 2000:

How Stocks Can Go Up When We’re Headed Towards a Recession

Here’s 2007:

How Stocks Can Go Up When We’re Headed Towards a Recession

Conclusion: this tends to occur when a recession and bear market has already started, or within 1 year of one. Long term risk:reward favors bears right. With that being said, there is no reason why the stock market cannot go up another 6-9 months.

Technicals: Medium Term

*For reference, here’s the random probability of the U.S. stock market going up on any given day, week, or month.

How Stocks Can Go Up When We’re Headed Towards a Recession

Although the bull market is certainly late-cycle, the stock market’s medium term (next 6-9 months) leans bullish.

Strong Reversal

The S&P fell 4 weeks in a row and then surged more than 4% this week.

How Stocks Can Go Up When We’re Headed Towards a Recession

Similar historical patterns could lead to a consolidation over the next few weeks, but this was mostly bullish 3-6 months later.

How Stocks Can Go Up When We’re Headed Towards a Recession

Let’s examine similar historical cases in which this pattern occurred while the S&P was within -5% of a one year high.

October 24, 2014:

How Stocks Can Go Up When We’re Headed Towards a Recession

July 2, 2000:

How Stocks Can Go Up When We’re Headed Towards a Recession

August 2, 1996:

How Stocks Can Go Up When We’re Headed Towards a Recession

November 29, 1963:

How Stocks Can Go Up When We’re Headed Towards a Recession

Each of these cases saw more gains over the next 3 months.

Low Treasury yields

Treasury yields continue to decline. Treasury yields and the S&P have been highly correlated recently. The 10 year yield’s 14 weekly RSI is now below 25.

How Stocks Can Go Up When We’re Headed Towards a Recession

Here’s what happens next to the S&P when the 10 year yield’s 14 weekly RSI falls below 25

How Stocks Can Go Up When We’re Headed Towards a Recession

While the 1 month forward returns are slightly bearish, the 6- 12 month forward returns are more bullish.

Here’s what happens next to the 10 year yield

How Stocks Can Go Up When We’re Headed Towards a Recession

Stocks vs. commodities

Stocks have significantly outperformed commodities recently, thereby pushing the S&P:CRB ratio more than 9.5% above its 200 day moving average.

*The CRB Index measures a basket of commodities.

How Stocks Can Go Up When We’re Headed Towards a Recession

While traders often assume this means that stocks will soon underperform and commodities will soon outperform, that isn’t usually the case.

Here’s what happens next to the S&P

How Stocks Can Go Up When We’re Headed Towards a Recession

Here’s what happens next to the CRB index

How Stocks Can Go Up When We’re Headed Towards a Recession

Sentiment

Sentiment continues to fall. Here’s AAII Bulls %.

How Stocks Can Go Up When We’re Headed Towards a Recession

Here’s what happens next to the S&P when AAII Bulls % falls below 23%, while the S&P is within 5% of a 1 year high.

How Stocks Can Go Up When We’re Headed Towards a Recession

Sentiment remains supportive for stocks 3-12 months later.

Defensives outperformance

Defensive sectors such as utilities have outperformed over the past year. The utilities ETF XLU is up more than 25% over the past year while the S&P is up less than 4%.

How Stocks Can Go Up When We’re Headed Towards a Recession

It’s common to see this as a bearish sign for stocks, because utilities (defensive sectors) outperformed during the 2000-2002 bear market. However, there have been 3 cases in which utilities outperformed by this much, and not all of them were bearish.

How Stocks Can Go Up When We’re Headed Towards a Recession

Here’s June 2016:

How Stocks Can Go Up When We’re Headed Towards a Recession

Here’s April 2005:

How Stocks Can Go Up When We’re Headed Towards a Recession

Here’s February 2001:

How Stocks Can Go Up When We’re Headed Towards a Recession

Fundamentals: Long Term

The stock market and the economy move in the same direction in the long run, which is why we pay attention to macro.

U.S. leading economic indicators are decent right now, which suggests that a recession is not imminent.

Let’s recap some of the leading macro indicators we covered:

Housing is a slight negative factor, but could improve

Housing – a key leading sector for the economy – remains weak. Housing Starts and Building Permits are trending downwards while New Home Sales is trending sideways. In the past, these 3 indicators trended downwards before recessions and bear markets began.

How Stocks Can Go Up When We’re Headed Towards a Recession

How Stocks Can Go Up When We’re Headed Towards a Recession

How Stocks Can Go Up When We’re Headed Towards a Recession

Labor market is still a positive factor

Despite yesterday’s weak jobs report, the labor market is still a positive factor for macro. Nonfarm payrolls is notoriously noisy from month to month, and it’s very common for nonfarm payrolls to miss expectations during an economic expansion.

How Stocks Can Go Up When We’re Headed Towards a Recession

That’s why it’s better to focus on the Unemployment Rate, Initial Claims, and Continued Claims.

The Unemployment Rate has yet to trend upwards.

  1. Its 12 month rate-of-change is still negative.
  2. Its 12 month rate-of-change was positive before prior recessions.

How Stocks Can Go Up When We’re Headed Towards a Recession

The Unemployment Rate’s 12 month % change being negative (blue line below) is much more bullish for the S&P than when the Unemployment Rate’s 12 month % change is positive (orange line below)

How Stocks Can Go Up When We’re Headed Towards a Recession

Initial Claims and Continued Claims are trending sideways. In the past, these 2 leading indicators trended higher before bear markets and recessions began.

How Stocks Can Go Up When We’re Headed Towards a Recession

How Stocks Can Go Up When We’re Headed Towards a Recession

Financial conditions

Financial conditions remain very loose and banks have not significantly tightened their lending standards. In the past, financial conditions tightened before recessions and bear markets began.

Here’s the Chicago Fed’s Financial Conditions Credit Subindex

How Stocks Can Go Up When We’re Headed Towards a Recession

Here’s the Credit Subindex level when historical recessions began.

How Stocks Can Go Up When We’re Headed Towards a Recession

Heavy Truck Sales

Heavy Truck Sales is still trending upwards. In the past, Heavy Truck Sales trended downwards before recessions and bear markets began.

How Stocks Can Go Up When We’re Headed Towards a Recession

Corporate Profits

The latest reading for inflation-adjusted corporate profits fell. In the past, corporate profits fell before recessions and bear markets began. Since corporate profits leads the S&P by 5-6 quarters, this is a long term bearish factor for the stock market beginning in Q1 2020.

How Stocks Can Go Up When We’re Headed Towards a Recession

Conclusion

Here is our discretionary market outlook:

  1. The U.S. stock market’s long term risk:reward is not bullish. In a most optimistic scenario, the bull market probably has 1 year left.
  2. Most of the medium term market studies (e.g. next 6-9 months) are bullish, although a few of trend following studies are starting to become bearish.
  3. Market studies over the next 1-2 weeks are mixed (some bullish and some bearish). Trade war news only adds to this uncertainty.
  4. HOWEVER, our market studies for the next 1-3 months are starting to turn more bullish.
  5. We focus on the medium-long term.

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

How Stocks Can Go Up When We’re Headed Towards a Recession

This was a Guest Post by: Troy Bombardia you can follow him on Twitter at @bullmarketsco and his website is BullMarkets.co.

***All content, opinions, and commentary is by Troy Bombardia and is intended for general information and educational purposes only, NOT INVESTMENT ADVICE.