Is It Time To Call Wall Street's Bluff?

Includes: DIA, QQQ, SPY
by: Lou Basenese

Brace yourself! The stock market is ripe for a nasty selloff.

The signs are so ubiquitous – and so obvious – that even retired politicos can sense the impending doom. In fact, they’ve graciously taken to the media to warn us helpless retail investors.

Retired Fed Chairman, Alan Greenspan, told Bloomberg that a “significant correction” lies ahead.

Former U.S. Representative, Ron Paul, insists that “the conditions are every bit as bad as they were in ’08 and ’09.” (Scared yet?)

Meanwhile, ex-Reagan adviser, David Stockman, swears that “the implosion is near.”

Politicians aren’t alone, either. The financial punditry keeps ushering in alarming data points to scare us stockless, too.

Over at Yahoo! Finance, a headline claims that the “big money” is dumping stocks. Institutions yanked a collective $7.97 billion out of equity ETFs last week. That’s the largest outflow since February, after which the Dow suffered a 5% pullback.

Then there’s The Wall Street Journal’s Chris Dieterich. He reports that “the pile of bearish options bets is growing larger by the day.” They outnumber bullish bets by a huge margin, and we’ve only witnessed such extreme negativity twice before in the past two decades. And in both instances, the lopsidedness preceded major market corrections.

In other words, we’re doomed, right? Not so fast…

I agree with Josh Brown, CEO of Ritholtz Wealth Management, when he says, “I’d rather pound a nail through my hand than try to guess when the next correction will be.”

Indeed! Besides, we have concrete evidence that now is not the time to give in to the fearmongering.

No Corrections Without Recessions

The S&P 500 has currently gone 1,030 days without a 10% correction. Impressive, yes. But history indicates that the streak could extend much longer.

From 1990 through 1997, the S&P 500 went 2,573 days without a 10% drop. And from 2003 through 2007, the S&P 500 went 1,833 days before buckling.

Sure, a correction is inevitable – eventually. Yet it’s impossible to know when with any certainty.

Here’s what I do know with certainty, though…

Overenthusiasm historically precedes market corrections or prolonged downturns. And, right now, we’re witnessing the exact opposite. The masses are fearful. And as Warren Buffett advises, that means we should be greedy.

Contrarian wisdom aside, it’s important to also recognize that bull markets historically end when recessions begin. And the two most reliable long-term recession indicators couldn’t be flashing a clearer signal…

Two Timely Recession Indicators

Recession Indicator #1: Recession Probability Index. Economist Jeremy Piger’s Recession Probability Index tracks four monthly variables used by the National Bureau of Economic Research (NBER), the official organization tasked with declaring recessions.

The time to get scared is when the probability spikes rapidly higher. Specifically, readings above 80% for three consecutive months have been a telltale sign of an impending recession.

The current reading checks in at a mere 0.92%.

Smoothed U.S. Recession Probability Index

Recession Indicator #2: The 2/10 Spread. Another trustworthy recession indicator is the 2/10 Spread – or the difference between interest rates on 10-year U.S. Treasuries and 2-year U.S. Treasuries.

It’s based on market (not government) data, for all you conspiracy theorists out there who are reluctant to embrace Piger’s Index.

The time to freak out is when the 2/10 Spread goes negative. Such dips historically precede recessions.

Spread Between 10-year and 2-year U.S. Treasuries

Granted, the spread is narrowing. But the current reading of 193 basis points is nowhere close to the danger zone, either.

Bottom line: A correction – or worse, the end of the bull market – is highly unlikely, given the current state of the economy. This week’s stronger-than-expected GDP report, combined with five months of employment growth of 200,000 jobs or more, points to an economy that’s accelerating, not downshifting.

Ignore the politicians doling out investment advice. It’s time to call the “smart money’s” bluff and stay invested.

Disclosure: None