Why This Crucial Market Barometer Matters Now

Quick! Run for the hills everybody…THE YIELD CURVE IS INVERTED!

As you’re probably aware by now, an ‘inverted yield curve’ is the bond market’s way of saying there’s a recession a comin’. In this case, we’re talking about recession in the world’s largest economy, the US.

This was the narrative that freaked global markets out last week, and led to a major plunge for Aussie stocks on Thursday.

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The funny thing is, this isn’t the first time the US bond market has ‘inverted’ this year. Back in March, Quartz reported:

The US yield curve has inverted, meaning that yields on short-dated three-month bills are higher than those on 10-year Treasury bonds, for the first time since 2007. This inversion, if it persists, has almost always preceded a recession, though it can take more than a year for it to happen.

But back in March, stock market investors didn’t give two hoots what the bond market had to say. In the typical mindless exuberance that occurs during the late stages of a bull market, the warning signs were blissfully ignored.

Equity market bulls continued to ignore those signs for months. In early July, Slate reported:

As of this week, the U.S. Treasury yield curve has now been inverted for a full quarter—an incredibly dull-sounding turn of events that happens to be an unusually reliable warning sign that an economic downturn is on the way. The yield curve has flipped prior to each of the last seven official recessions over the past 50 years, without a single false-alarm during that stretch. If securities could talk, in other words, they’d be screaming bloody murder about trouble ahead.’

Still, no one listened. They don’t call it a bull market for nothing. Who wants to get into a rational argument with a bull when it has a full head of steam?

But now it’s a different story. Now investors want to freak out about the ‘inverted yield curve’.

This is what differentiates a bull and bear market. It’s all about the psychology. In a bull market, you’ll get trampled if you try to stop the bull with a rational argument. In a bear market, people lose their minds when confronted with rational arguments.

More than anything else, it’s this shift in investor psychology that tells me we are in the early stages of a bear market.

Usually, the market must fall 20% from its peak to trigger a bear market according to the popular definition. But as far as I’m concerned, it’s a poor definition.

The other way of looking at it is to consult the charts. Everyone has a different way of interpreting charts, some being better than others. I use a very simple set up that tries to determine the medium-term trend of the market.

To do that, I use 50-day and 100-day moving averages (MAs). MAs smooth out the day-to-day market volatility and allow you to see the underlying trend of the market.

Let’s take a look at the S&P 500 to see how it’s traveling based on this analysis…

S&P 500 Index - SPX (WI)- 1 DSay Bar Chart - USD - 19-08-19

Source: Optuma

[Click to open in a new window]

If the MAs represent the underlying trend, then as you can see the trend is still bullish. In fact, the 50-day MA has only just started to turn down. From a charting perspective, it’s not until the 50-day MA turns down and crosses below the 100-day MA that you can say the trend might be turning.

That’s why I said earlier that we’re in the early stages of a bear market. Note, this view isn’t yet backed up by charting analysis. But it is supported by that nebulous concept of market psychology.

And as far as I can tell, the psychology of the market has turned from bullish to bearish. Only the Federal Reserve going full retard can change things from here. Trump would like that, but I’m not sure it’s going to happen.

With this in mind, let’s have a look at a couple of charts relating to the local market.

The ASX 200 Resources Index has been the driving force of the 2019 rally. It’s corrected sharply over the past few weeks and is now coming up to longer-term support.

The MAs suggest the trend is still bullish. But a break below support would be a major concern, especially if it coincided with the MAs turning down.

S&P/ASX 200 Resources - XJR (ASX)- 1 Day Bar Chart - USD - 19-08-19

Source: Optuma

[Click to open in a new window]

The ASX 200 Financials Index is around 30% of the overall market. It’s still in a bull trend too, but has corrected sharply in recent weeks. Maybe interest rates heading towards zero won’t be as good for the banks as investors previously thought?

S&P/ASX 200 FInancial-x-Property Trusts - XXJ (ASX) - 1 Day Bar Chart - AUD - 19-08-19

Source: Optuma

[Click to open in a new window]

Finally, the Small Ordinaries Index (which measures the performance of the small-cap sector) has also reversed sharply in recent weeks. The index rallied 26% from the December 2018 low to the July high, but has given some of that back quickly.

More falls look likely, and it wouldn’t surprise me to see it happen soon.

S&P/ASX Small Ordinaries - XSO (ASX) - 1 Day Bar Chart - AUD - 19-08-19

Source: Optuma

[Click to open in a new window]

Note how, on all three charts, the recent correction took the indices straight through both the 50 and 100-day MAs. In a bull trend, these MAs usually act as support.

Also note how on the latter two charts, the minor bounce found resistance at the 50-day MA.

By themselves these are minor things. But given the situation we are in, they are additional evidence that the mood of the market is changing.

I hope you’ve taken note.


Greg Canavan,
Editor, The Rum Rebellion

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Greg Canavan approaches the investment world with an ‘ignorance is bliss’ philosophy. In a world where all the information is just a click away at all times, Greg believes we ingest too much of it. As a result, we forget how to think for ourselves, and let other people’s thoughts cloud our own.

Or worse, we only seek out the voices who are confirming our biases and narrowminded views of the truth. Either situation is not ideal. With regards to investing, this makes us follow the masses rather than our own gut instincts.

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