I have been cautious about the overall market going back to January when investor sentiment was the highest it had been since 1987, at least according to the Investors Intelligence survey. I have written several articles on different websites encouraging investors to take action to protect their portfolios. There were just too many concerns for me to be comfortable keeping the same old asset allocation model.
Some of the concerns I have addressed are:
- Investor sentiment was too high
- Rising interest rates with a possible yield inversion
- A 2% climb in the 10-year Treasury rate
- Consumer confidence too high
- Negative reaction to earnings beats
- Indices falling below their long-term moving averages
- Transportation and small-cap indices leading the market lower
If there was just one or two of these things going on, I would be more inclined to think that a correction or a consolidation would be in the works. But when there are all of these things happening or on the verge of happening all at the same time — now it becomes a bigger concern.
Investor Sentiment and Consumer Confidence as Contrarian Indicators
One critical part of my investment analysis is sentiment. It doesn’t matter whether it's an individual stock, a sector, or the overall market. When investors are too optimistic, that's when the subject investment tends to fall.
One popular sentiment survey is the Investors Intelligence sentiment survey. This survey showed a ratio of bulls to bears over five to one back in January. After the initial pullback in the market in January, this indicator has fallen and is now down around two to one. When we have been in a bear market, this ratio has usually been under one when the downturn ended.
One indicator that I have studied and come to view as a contrarian indicator for the market is the Conference Board’s Consumer Confidence Index. When the index gets too high and then starts falling — it has been a bad sign for the economy and the market.
The reading in October was 137.9 and that was the highest reading since September 2000. The November reading was just released last week and it was at 135.7. That isn’t a big drop, but it’s definitely something I'm keeping an eye on.
I created the following chart to show how the Consumer Confidence index and the S&P 500 have moved over the last 20 years.
You can see that consumer confidence was really high in the late 90s and it stayed elevated for quite some time. It peaked at 144.7 in July 2000 and then started falling. I looked at different pullbacks to see how much the index needed to pull back before it became a concern and 10% seemed to be the most foretelling.
By February 2001, the index had fallen by 10% and that was when the selling accelerated. Yes the S&P had peaked earlier, but from Feb. 1, 2000, to the low in October 2000, the index fell another 43%.
Jumping ahead to the 2007 timeframe, the Consumer Confidence index peaked at 111.9 in September 2007. By November of the same year, the index had fallen more than 10%. Once again we see that the S&P had peaked a few months earlier, in September to be precise. From Nov. 1, 2007, to the low in March 2009, the index fell another 55%.
With this in mind, I'm watching the Consumer Confidence readings to see if they are moving higher or lower. Right now the highest reading has been the 137.9 reading in October. A drop of 10% would mean a reading of 124.11. If we get a reading that low, that will be a confirmation point for me.
Interest Rates Climbing and Possibly Inverting
Most of us have heard about how a yield inversion is a warning indicator of an impending recession. In most cases when analysts talk about a yield inversion they are referring to interest rates on the two-year Treasury being higher than the 10-year Treasury. That relationship is the most closely watched and it's in the spotlight right now.
The spread between the two rates dropped to less than 15 basis points this week and that's the lowest spread we have seen since 2007. As of this writing, the spread was at 12 basis points.
There actually was a yield inversion this week as the three-year Treasuries were yielding more than the five-year Treasury. This event got very little attention, but it's certainly worth mentioning and could be a sign that the two-year and 10-year will invert in the near future.
During some research about yield inversions, I discovered another tool that I personally track. It's the 10-year Treasury yield and where it's compared to its most recent low. What I discovered was that when the 10-year yield has jumped by 2% from the low, it often indicates a downturn in the stock market.
In the current trend, the low was 1.336% in July ’16. That would mean the 10-year would have to reach 3.336% to trigger this indicator. We haven’t gotten there yet, but the yield did reach 3.248% in October and that's awfully close.
We see on the chart the instances where the 10-year jumped by 2% in the last 20 years. From October 1998 to January 2000, the yield jumped from a low of 4.101% to a high of 6.823%. The S&P peaked in March 2000 before consolidating for a few months and then started trending lower later that year.
The 10-year rate reached a low of 3.074% in June 2003 before starting to climb and peaking at 5.316% in June ’07. The S&P 500 peaked in October 2007.
There's one other blue box on the chart and that was a close call that didn’t quite reach the 2% jump. From December 2008 through April 2010, the rate jumped from 2.038% to 4.013%.
We didn’t see a bear market in that instance, but we did see a two-month pullback that saw the S&P lose over 15%. We also have to take note that the environment we were in at the time was one where the economy was still recovering from the “great recession” rather than at the end of an expansion cycle.
You may be asking, “Why would a 2% increase in the 10-year treasury mean anything to the stock market?”
I came up with two possible explanations for this phenomenon. First, the 10-year is a benchmark for a number of different lending rates — most notably mortgage rates. A 2% increase in Treasury rates leads to significantly higher borrowing costs for consumers and businesses.
Secondly, investors who are looking for income producing investments will look at high yielding stocks when Treasury rates are too low. When interest rates start to climb, they will reach a certain point where income investors are willing to move back into Treasuries rather than take on the risk of investing in stocks. The risk-reward relationship gets flipped and the “risk-free” rate becomes attractive enough to lure investors away from higher risk, higher yielding stocks.
Indices Crossing Below Moving Averages and Specific Industries Falling First
Charles Dow developed his investment ideology in the late 1800s. He didn’t call them the Dow Theory, but his notes and papers would become what is now known as the famous theory. One of the ideas that has always stood out to me from the Dow Theory is the idea that you need to watch the relationship between transportation stocks and industrial stocks.
Dow’s theory was that if industrial stocks were going to move higher, transportation stocks needed to be moving higher as well. The idea being that if industrial companies are producing more, the transportation companies are going to be one of the first beneficiaries. To produce more end goods, industrial companies will need more of the components and materials that go into the finished product before that production increase.
Conversely, if there's a slowdown in production, it will be reflected in transportation companies first as the industrial producers will order less components and materials and thus the transportation companies won’t be as busy.
Granted our world has changed dramatically since Charles Dow developed these ideologies, but there's a certain logic to this idea that still rings true today. Our economy isn’t nearly as dependent upon industrial companies and technological advances have changed how goods and services are delivered. But transportation still has to happen for many consumer goods.
In addition to the transportation industry, I think investors need to keep an eye on the Russell 2000 index. The Russell represents small-cap stocks and it is considered a riskier investment class than the blue chip companies in the S&P 500.
If you see the Russell moving down while the S&P is still moving higher, it could be a sign that the overall risk appetite of investors is changing.
Where do we stand currently?
I should probably explain the moving averages that I use first. I don’t use traditional round-number moving averages like a 10-week or a 20-week. Those are random round numbers. I like to look at the 13-week moving average because it represents one quarter of data. I use a 52-week to represent one year and the 104-week to represent two years.
With that being said, the Russell 2000 is below its 104-week moving average and it is the first of the main four U.S. indices to cross below that threshold. It's also the only one of the main four that has seen its 13-week moving average cross bearishly below its 52-week moving average.
On a year to date basis, heading into Thursday’s trading, the Russell was down 3.57% and that was the worst performance of the four indices. The Dow, S&P, and Nasdaq were all still in positive territory for the year — again before Thursday’s trading opened.
The Dow Jones Transportation index ($TRAN) is below its 13-week and 52-week moving averages and it has dipped below its 104-week on a few occasions, but hasn’t closed below the trendline yet. The 13-week has just crossed below the 52-week moving average this week.
Like the Russell 2000, the Transportation index was in negative territory before the market opened on Thursday.
Looking back at the last bear market, the transportation index and the Russell were both underperforming the other indices before the top in the market. The chart below shows the performances of the Dow, Nasdaq, Russell, S&P and the Transportation Index from the end of 2006 through Nov. 21, 2007. The Russell dropped just over 6% during this period while the TRAN dropped 4.25%. The other indices were flat or showed positive returns during the period.
The time period measured in the chart above is 226 trading days. Since the beginning of 2018 through the close on Tuesday was 235 trading days, so we are talking about two similar time periods in terms of length.
Seeing the Russell and the Transportation index lead the way lower like we saw in 2007 is definitely adding to my bearish posture.
What It All Boils Down to is This
If we were only dealing with the trade war, I wouldn’t be as concerned. If we were only dealing with rising interest rates, I wouldn’t be as concerned. If we were only dealing with high consumer confidence readings, I wouldn’t be as concerned. But we aren’t just dealing with the trade war, or rising rates, or high consumer confidence. We are dealing with all three and we are looking at a possible rate inversion and the indices making bearish crossovers of their moving averages.
This could still turn out to be a correction or a consolidation like we saw in 2015, but I don’t think it is. There are too many factors that are stacking up that remind me of 2000 and 2007.
My suggestion to investors is to take action to protect your assets. If you still have the bulk of your portfolio in stocks, change your asset allocation and move some money in to fixed income. Buy long-term put options on the overall market to act as portfolio insurance. Invest part of your portfolio in an inverse ETF on the overall market.
Any of the actions above will help in a bear market, you could do one of the above or you could do all three. The worst thing you could do right now is nothing.
To give you an idea of how big of a difference some relatively small changes can make, I put together the following table to show how three different portfolio strategies would have done from Aug. 1, 2007, through the end of the bear market on March 9, 2009. I used the SPDR S&P 500 (SPY), the iShares 20+ Year Treasury Bond ETF (TLT) and the ProShares UltraShort S&P 500 ETF (SDS) to represent stocks, fixed income and bearish investments.
The dates I chose represent almost perfect timing, but even if you didn’t time things perfectly, taking action in November of 2007 would have been better than doing nothing. Getting out of the bearish SDS too late wouldn’t have produced the same results, but it would have been better than doing nothing.
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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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.