In my colleague’s recent blog post (https://catalyst-insights.com/is-the-bond-market-giving-us-a-warning-sign/), he cautioned that bonds and the Chicago Board Options Exchange’s CBOE Volatility Index (VIX) were giving us a warning sign. That said, here is the next indicator I’m following.
The end of 2019 as pictured below looked as if the rates were heading higher, and it looked like the economy was on a solid growth track; however, that has all broken down as investors fear of stocks and a global slowdown has forced people into safe havens, like the 10-year Treasury note
The recent drop in interest rates in the bond market has pushed the indicative dividend yield on the S&P 500 to a 60 basis points (bps) premium to the 10-year bond yield. If you factor in that dividends have a lower tax bracket potentially, the yield difference is even greater.
Recently, I discussed how there are many similarities to 2007, with volatility and bond prices moving together. Couple some economic data like housing permit growth, PE for stocks, a rally in gold, and household debt all looking like 2007 numbers with volatility and bonds looking like investors are getting ready to head for the hills in the stock market, and the backdrop looks like a recession is imminent.
However, the one silver lining that might give investors a second look at stocks is the relationship between the S&P 500 dividend yield and the 10-year note interest rates. The 10-year yield has fallen below the S&P yield a handful of periods in the last 10 years and each time that has presented itself with an opportunity to own stocks. You don’t necessarily get an instant turnaround in stocks, but 6-12 months from now is likely to see higher stock prices.
On a closer look recently, the flip flop of interest rates and dividend yields has also marked the end of a volatile sell off in stocks.
Part of the catch 22 recently has been that bonds have been rallying as if to say that economic growth is slowing dramatically, and stocks have surged to 2007 level forward P/E numbers suggesting that the economy is heating up. Interestingly the data domestically in 2020 has been quite good so it seemed as if rates should not be going lower. Yet they are, and historically whenever they have been this stretched out its been the end of a selloff, even if this selloff is not as dramatic as recent ones.
So where am I looking if the selloff is not part of a larger global economic slowdown, or the start of the end of the world, I mean how do you really hedge that, then the place I would look to put money back to work is the semiconductor Index. The uptrend is still intact, and they have been hit the hardest due to the shut-down concerns. However, if this just turns out to be a temporary slowdown and if I had some cash on the sidelines, it might be an interesting place to own. I think you can keep a tight stop on around $132 mark in SMH or use some call options to define risk and get upside exposure. I also think value investing makes sense as well if you own it with the semiconductors because the semis will provide enough an upside volatile move if today’s sell off is a one-day price correction.