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A Market Rally Is Imminent

|About: SPDR S&P 500 Trust ETF (SPY), QQQ, DIA
Summary

The most important economic indicators are bullish.

The 10-2 year treasury yield curve did not invert.

Technical indicators suggest an immediate rally is likely.

The pertinent question at hand: is the US economy heading into a recession that will cause a bear market? The stock market has been through a sell-off brought on by trade war concerns, poor world-wide economic data, and a brief yield-curve inversion, but does that mean a recession is likely? In this piece, I will outline why I think the answer to these questions is no, and why I think it is a buying opportunity.

There are endless economic indicators, it is essential to determine which indicators are most useful for anticipating a recession. I believe the most pertinent factors for the American economy are the job market and credit delinquency. The American job market has been robust, credit delinquency has not begun to increase, and the 10-2 yield curve has not inverted yet.

Additionally, reliable technical indicators are showing signs that this sell off is over and a rally should ensue.

Fundamental / Economic Data

The American economy is based 68% on consumer spending ($14.24 Trillion of the $21.06 Trillion for Q1 2019), therefore, having a healthy consumer goes hand in hand with an expanding economy and a generally increasing stock market.

Initial Claims

Source: FRED

The chart above outlines how initial unemployment insurance claims tends to stagnate or rise before a recession. As of now, it is still decreasing. This suggests the job market is robust, ensuring the consumer can spend keeping the economy expanding.

Credit Delinquency

Source: FRED

The above chart shows delinquency rates on all loans. Credit delinquency goes hand in hand with a healthy job market. So long as the job market is robust, people will be able to service their credit. This is another sign of a healthy consumer that will be able to keep the economy expanding.

This is the mechanism by which modern recessions start: the job market weakens, people lose their jobs, therefore they can no longer service their credit and they are unable to spend, which causes the economy to contract and a bear market to ensue. This mechanism is valid for the US economy, as the US economy is composed of 68% consumer spending. There are other economic indicators that are useful, but for anticipating recessions the job market and credit delinquency rates are two of the most important indicators and they are both bullish meaning recession fears are overdone.

Yield Curve Inversions

On Wednesday morning, the 10-year and 2-year treasury spread briefly went negative (a yield curve inversion). This sent shock waves throughout global markets and the financial news media. The yield curve has since righted itself. Additionally, this inversion was unlike prior inversions which suggest that it was mainly brought on by quants and algos and, as of now, does not have the economic implications of past inversions.

The above chart is the 10-year and 2-year treasury spread from August 2017 to present. It illustrates two things: the first being that the yield curve has not inverted, the second being that this is a very unusual movement in treasuries. I believe this move shows algos were running wild, but have no data to support this, other than the objectively wild bond trade that is taking place in world-wide credit markets. I will not get into that here as I am not an expert on bond / credit markets.

This dramatic move in the rate differential also suggests that the sell off on Wednesday was overdone, leaving a buying opportunity.

The chart above is the 10 year – 2 year treasury spread from March 2004 to March 2006. This shows a very orderly and measured move in the 2 years prior to inversion.

The above chart is the 10 year – 2 year treasury spread from August 1996 – August 1998. This move is also more measured and consistent compared to the recent yield curve activity. As mentioned above, I am unclear what the implications are for the market and economy, but it is safe to say that something is different about the most recent yield curve activity. It is also worth repeating that the 10-year and 2-year yield curve is not inverted. The fact that the 10-2 year treasury yield curves are not yet inverted suggest that the credit market is not yet signaling recession.

Technical Indicators

The following technical indicators suggest this sell off is over or nearly so.

Traders Index / Arms Index

The above chart is the 10 day moving average of the TRIN (Short term traders / Arms index). This oscillator measures advancing and declining stocks and takes into account the volume on those stocks. The blue line is the 10 Day moving average of the TRIN while the black line is the SPX. The 10 day moving average spikes up when there is an extended sell off. This is the largest up spike of the 10 DMA over the last three years. Over those three years, the 10 DMA has eclipsed 1.35 three times (as shown by the red rectangles above) and an immediate rally ensued on 2 of those occasions, while a rally followed on the other occasion after the market made a lower low. On the most recent up spike, the 10 DMA reached 1.55, which is the highest mark since late 2015 where an immediate rally ensued.

SPX Advance Decline Percent Index

The above chart shows the 10 DMA of the SPXADP in relation to the SPX. The 10 DMA tends to shoot lower as sell-offs are nearing their end. The 10 DMA has had a large down spike and reached as low as -20. Over the last three years, this is the 6th down spike to reach this level. All five of the previous down spikes led to immediate rallies. There was one retest whereby the market rallied immediately and then sold off to the same level weeks later (Feb. and Apr. 2018). There was also one occurrence where the market rallied immediately only to make a lower low 8 weeks later (Oct. 2018). Three of the five occurrences led to immediate, multi month rallies. This suggests a broad market rally is imminent in the short term.

McClellan Oscillator

The above chart is the 10 DMA of the McClellan Oscillator in relation to the SPX. The 10 DMA on this oscillator tends to shoot down as sell offs are nearing their end. Over the last three years, the 10 DMA has eclipsed -30 on nine previous occasions. Only two of those nine occasions saw the SPX decline more. Five of the nine occasions led to immediate rallies. One of those occasions had an immediate rally that had a lower low on a multi week basis. This supports the idea that an immediate rally will ensue in the broad market.

Equity Put Call Ratios

The above chart shows the 10 DMA of the Equity Put Call Ratio index and the SPX. This index shows the level of hedging that takes place on equities and shoots higher as sell offs are nearing their end. Over the last three years, the 10 DMA of the EPC ratio index has eclipsed .76 on four occasions. On all four occasions, the market rallied immediately. Only on one occasion (Nov. 2018) did the market break to a lower low after the immediate rally. This supports the idea that a market will rally immediately.

In summation, the pertinent economic indicators are still bullish meaning a recession and bear market are not imminent. Breadth and sentiment technical indicators support the idea that an immediate market rally will ensue making this market dip an opportunity for those that have funds to buy the dip.

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

Additional disclosure: Although I am not invested in the SPY, QQQ, or DIA, I am invested in high beta assets to take advantage of what appears to be an impending rally. Additionally, this piece was originally written as an article on Saturday, August 17th, however, it was rejected as SA doesn't believe it meets their criteria.