This Market Bubble Will Pop

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Includes: DIA, IWM, QQQ, SPY
by: Scout Finance

Summary

The yield curve has been flattening. The Fed has artificially steepened the curve, so it doesn't have to go inverted to signal a recession.

Announced buybacks are down the most since 2009.

Equities should be avoided.

The economic cycle is rolling over. There are occasional positive glimpses within the downtrend, but with earnings down 4 quarters in a row, Q1 GDP at 0.5%, and banks tightening their lending standards for 3 consecutive quarters, the trend is clearly lower. As an investor I look at my portfolio from a total asset allocation perspective with the business cycle in mind. High beta, cyclicals must be avoided. However, we are getting to the point where even low-beta consumer staples are getting close to peaking. At the end of the cycle, stocks like McDonald's do well because they provide consistency in an uncertain world. However, if you look at any market correction these stocks fall along with the market as ETF selling tends to drag them down.

One of the two most important indicators I look at are buybacks and the yield curve. Buybacks are what drive stock prices as firms are the biggest buyers in the market. The yield curve is far more indicative of what's driving the market than equities. Equities are ripe with speculation which is focused on individual firms like Facebook and Amazon which can actually single handedly drive the market higher. The yield curve is solely directed by macro trends.

Anyone who is looking at the yield curve can notice it is flattening. Even CNBC noticed it was flattening. It promptly said the indicator was broken, which I find biased. It's childish to argue a signal is broken because it doesn't fit your narrative. The reality is we won't know it is broken for another 12 months when we find out if the economy actually does hit a recession.

As I said, anyone can stare at the yield curve all day, but it's not a magic formula that will tell you when stocks will go up and down. There is no magic formula that spits out when stocks go up. Analysis needs to be done and context needs to be given. With the case of the yield curve, the Fed has artificially steepened the yield curve during the past few cycles. As you can see, the difference between the 5 year and the 10 year bond yield has been making higher highs and higher lows. That would indicate the yield curve doesn't have to go negative to indicate a recession. If it falls a few basis points, it will reach the bottom end of the curve.

As I said, corporate buybacks are the largest buyer of stocks. The amount of announced buybacks are down by the most since 2009. This makes sense because earnings are down 8.7% in Q1. Firms cannot justify buying back their stocks with their earnings declining. As you can see, buybacks still have a lot of room to fall which implies the market has room to fall as well.

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Conclusion

I would own as little equities as possible. I have been negative on stocks which has led investors who followed this advice to lose a massive 0.4% in opportunity cost. I can deal with missing out on that gain if the market does sell off later this year.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.