In May of 2017, we presented evidence in support of our view that the stock market, at the time, was not about to enter a bear market. Six months later, we updated this evidence and concluded that the market was overdue for a healthy correction, but that a recession and resulting bear market were still many months away. Now, one year after the original article, we revisit the evidence to see how the situation has changed.
Rate Differential and Unemployment
When the 10-year minus the 2-year Treasury rate inverts, it is a warning sign of an impending recession and accompanying bear market. This negative differential is a leading indicator which turns negative many months before the S&P 500 makes a top. A year ago, in May of 2017, the differential was at +0.96, and we noted that if the downward slope stayed constant, then the inversion was on track to happen in the last half of 2018 and a recession a further 12-to-18 months past that (chart below).
Six-month ago, in November of 2017, the differential was at +0.59 with a similar slope as before and with the same approximate inversion date of H2 of 2018.
Now, one-year after the original article, the 10-year minus 2-year differential is at +0.42 and, again, if the slope is maintained, the inversion would take place later in 2018 or early 2019.
It should also be noted, that the unemployment rate has been steadily dropping and that in both of the last two bull markets the rate started to rise several months ahead of the market making a top. The fact that unemployment continues to drop, combined with the positive rate differential, makes it unlikely that we have already seen the highs of the present bull market.
Fed Funds Rate
The Federal Reserve kept rates zero-bound for the first seven years of the current bull market but has been slowly raising rates for two years now. It is a common belief that rising rates and bull markets don’t mix, but the facts prove otherwise. The last four rate-hiking cycles have taken place during bull markets. Rising rates do not cause bear markets, overly high rates cause bear markets. And what constitutes overly-high rates has been steadily decreasing since the 1980s (chart below).
The downward-sloping trend line implies that rates will top out between 2% and 3% early in 2019 if the Fed sticks to its advertised tightening schedule (blue oval in chart above). That timing roughly fits with the rate differential, which we discussed above, and would require at least two quarter-point rate hikes by the Fed. Again, a bear market is not close at hand.
Six months ago, GAAP earnings were 104.02. Today, they are 5% higher at 109.88 (chart below). Bear markets do not start while earnings are increasing.
Rising industrial production correlates strongly with bull markets, and one-year later, production continues to increase. Rising industrial production does not start bear markets.
The eight-month moving average (8 MA) continues above the 12-month moving average (12 MA), the S&P 500 has bounced off the 8 MA, the MACD is veering away from a cross-over, the RSI is rising again, the stochastic is no longer over-bought, and the +DI is no longer extended. Bear markets do not start with technicals like these.
In fact, the recent trading is technically similar to the trading of 1998-2000 (pink highlights in the chart below), which was followed by a 35% rally to the top of the tech bubble. We expect new highs before this bull morphs into a bear.
Even local tops, not just major tops, correlate with the AAII bull-minus-bear investor sentiment differential; 57% of local tops have occurred when the differential was above 40%, while only 16% of tops occurred when the differential was less than 15%. In January, the differential peaked above 40% as the S&P 500 made a new high, but now is at only 8.5% despite the market recovering with higher-highs and higher-lows. There is still too much fear for this to be the start of a bear market.
In conclusion, since November, when we last reported, the market has experienced a much-needed correction, but its fundamental, technical, and sentiment indicators continue to support our thesis that we are NOT at the start of a bear market. We are likely closer to the end of this bull market than we are to its beginnings, but a recession and resulting bear market are still many months away.
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