Looking for a stock market crystal ball? Watch the bond market
Wouldn’t it be nice to have a crystal orb that forecasts the future of the stock market—a tool that would help investors experience fewer surprises and mitigate risk?
While no one will ever be able to look into a stock market crystal ball to see what’s ahead, there is something investors can monitor to help identify stock market shifts – the bond market.
Reading the Fixed Income Variables There are two fixed-income variables that have a strong track record of predicting looming recessions and significant changes in the stock market direction: the slope of the yield curve and high-yield spreads. When evaluating these two variables, if one changes course, it signals a yellow flag. If they both change at the same, time, then a shift in the market can be expected.
Yield Curve Predictions for the Market and the Economy The slope of the yield curve, the difference between the two-year and the 10-year Treasury yields, has a virtually perfect track record of predicting oncoming recessions. Historically, there is a lag effect—once the yield curve flattens and becomes inverted (long rates lower than short rates), the economy goes into a recession within 12 to 24 months. Why is this important? Equity bear markets (when stocks are down 20 percent or more) are associated with recessions. In recessions, economic activity slows and companies’ sales decline, leading to a contraction in earnings that results in a stock market debacle. The yield curve has been flattening over the past few years. Currently, the spread is 50 basis points, but it does not appear that the yield curve will invert, meaning we believe that neither an economic recession nor an equity bear market will occur in 2018. We anticipate the economy will continue to move along at an increasing pace, creating more competition for workers and higher wages. This should keep interest rates moving up, and will modestly increase the yield curve slope throughout this year. However, we are closely watching the yield curve slope for an inversion, as this will be a yellow flag for the economy and markets.
High-Yield Spread Warning Signs Spreads on high-yield bonds are another great barometer for oncoming pressure in the stock markets. These spreads show the difference in yield between low-grade corporate bonds (junk bonds) and U.S. treasury notes. The spread tends to widen (increase) before major sell-offs in the stock market, and typically occurs several months before the stock market peaks and begins a downward cycle. The last four major changes in the equity market were preceded by a widening of high-yield spreads. Currently, high-yield spreads are anchored near cyclical lows and are showing no warning signs that a significant negative cycle for stocks is close at hand. Historically, when spreads materially widen, it is also a yellow flag.
2018 Stock Market Crystal Ball Conclusion There is no stock market crystal ball when it comes to predicting stock prices. However, as outlined, the bond market provides clear warning signals to monitor. If the yield curve inverts and high-yield spreads widen at the same time, this is a red flag that signals the economic cycle and the bull market are close to a material change of direction.
Currently, this is not the case. At this time, both of these indicators are sending the “all clear” signal. We are deep into this economic expansion, so we are watching these signals very closely. As we’ve seen in the past, they might once again provide important warning signs that lead us to reduce equity exposure. In the meantime, it appears that for 2018, the stock market crystal ball is indicating that it should be another year for reasonable equity market returns. To stay informed of the latest market trends, sign-up to receive economic updates and follow UMB‡ and KC Mathews‡ on LinkedIn.
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* Economic update 2018: Check the rearview, but stay focused on the windshield
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