The question I get most often is, “when is the next bear market?” Three specific items tend to predict bear markets and recessions with some accuracy.
However, before we get to those points, a “bear market” requires excesses that need reversion. In other words, a mean-reverting event needs “fuel.” Several measures suggest excesses are sufficient to fuel a meaningful reversal.
Deviation From Long-Term Means
Household Equity Ownership
Importantly, none of these measures mean a “bear market” is imminent. Instead, it requires a catalyst to cause a change in sentiment from “greed” to “fear.” As noted, three indicators historically denote when the “clock starts ticking” to the next bear market.
The yield curve is one of the most important indicators for determining when a recession, and a subsequent bear market, approaches. The chart below shows the percentage of yield curves that invert out of 10-possible combinations.
Investors should never dismiss the message sent by the bond market. Bonds are essential for their predictive qualities, which is why analysts pay an enormous amount of attention to U.S. government bonds, specifically to the difference in their interest rates. Why is this?
Unlike stocks, there is a finite value to bonds. At maturity, the lender receives the principal along with the final interest payment. Therefore, bond buyers are aware of the price they pay today for their return tomorrow. Unlike an equity buyer taking on “investment risk,” a bond buyer is “loaning” money to another entity for a specific period. Therefore, the “interest rate” takes into account several “risks:”
Economic growth risk
Since the future return of any bond, on the date of purchase, is calculable to the 1/100th of a cent, a bond buyer will not pay a price that yields a negative return in the future. (This assumes a holding period until maturity. One might purchase a negative yield on a trading basis if expectations are benchmark rates will decline further.)
Therefore, since bonds are loans to borrowers, a bond’s interest rate is tied to the prevailing rate environment at the time of issuance.
Therefore, there is a high correlation between rates, the economy, and asset prices over the long term. Oil prices, trade tensions, political uncertainty, the dollar, credit risk, earnings, etc., are reflected in the interest rate for different durations of loans.
Which Yield Curve Matters
Which yield curve matters mostly depends on whom you ask.
DoubleLine Capital’s Jeffrey Gundlach watches the 2-year vs. 5-year spreads. Michael Darda, the chief economist at MKM Partners, says it’s the 10-year and the 1-year spread. Others say the 3-month and 10-year yields matter most. The most-watched is the 10-year versus the 2-year spread.
So, which is it? As discussed in “Which Yield Curve Matters:”
“The best signals of a recessionary onset have occurred when a bulk of the yield spreads have gone negative simultaneously. However, even then, it was several months before the economy actually slipped into recession.”
Following the “Dot.com” crash, the entire tragic event was considered an anomaly, a once-in-a-100-year event that would not replicate again. Unfortunately, just 4-years later, in 2006, investors again were told to ignore the yield curve inversion as it was a “Goldilocks economy” and “sub-prime mortgages were contained.”
Advice to ignore yield curve inversions has not worked out well for investors.
The quad-panel chart below shows the 4-previous periods where 50% of 10-different yield curves became inverted. I have drawn a horizontal red dashed line where 50% of the 10-yield curves we track are inverted. I have also denoted the optimal point to reduce risk relative to the subsequent low.
In every case, the market did rally a bit after the initial reversion before the eventual reversal.
No Inversion Yet
The chart below is the percentage of the 10-yield spreads that are currently inverted. At the moment, that number is at zero suggesting there is no risk of a recession or “bear market.” However, as you will note, when inversions occur, they tend to happen quickly.
Historically speaking, from the time yield curves begin to invert, the span to the next recession runs roughly 9-months. However, note that yield curves are currently declining, suggesting economic growth will weaken. If this trend continues, another “inversion” would not be a surprise.
Given the strong track record of predicting recessions historically, when the subsequent inversion occurs, the media will quickly dismiss it as they did in 2019.
They will likely be wrong again.
Recently, the Federal Reserve stated they are “thinking about thinking about tapering” its bond purchases. However, the issue of “tapering” is not as much about the Fed’s actual reduction of bond purchases as it is about psychology.
“The key to navigating Quantitative Easing! and Fed policy in general is to recognize that their effect on the stock market relies almost entirely on speculative investor psychology. See, as long as investors get inclined to speculate, they treat zero-interest money as an inferior asset, and they will chase any asset with a yield above zero (or a past record of positive returns). Valuation doesn’t matter because investor psychologically rules out the possibility of price declines in the first place.” – John Hussman
In other words, “QE” is a mental formation. Thus, the only thing that alters the effectiveness of the Fed’s monetary policy is investor psychology itself.
Such was a point made in the “Stability/Instability Paradox.”
“With the entirety of the financial ecosystem now more heavily levered than ever, due to the Fed’s profligate measures of suppressing interest rates and flooding the system with excessive levels of liquidity, the ‘instability of stability’ is now the most significant risk.”
There is a correlation between expanding the Fed’s balance sheet and the S&P 500 index. Whether the correlation is due to liquidity moving into assets through leverage or just the “psychology” of the “Fed Put,” the result is the same.
Therefore, it is no surprise that market volatility increases when the Fed starts “tapering” their bond purchases. The grey shaded bars show when the balance sheet is either flat or contracting.