Yield Curve Panic is Premature

Despite strong technicals and robust earnings, the stock market seems a little confused

CMT, Senior Market Strategist
Jul 23, 2018 at 8:49 AM
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With 67 of the S&P 500 companies reporting earnings this past week and an abundance of economic news, the stock market had all the ingredients for an exciting week. Instead, the market seemed to carry on in a lethargic manner as if it was in a confused state of mind, primarily because it keeps getting mixed signals daily. On the one hand, you have upbeat economic data, robust positive earnings beats, a resilient market that shakes off bad news, and bullish technicals. On the other hand, you have a volatile news cycle coming out of Washington, D.C., that seems to keep the market only cautiously optimistic.

The S&P 500 Index (SPX - 2,801.83) and the SPDR S&P 500 ETF Trust (SPY - 279.68) finished out the week higher, but mostly flat, adding only 0.02% and 0.03%, respectively. The SPX tested key support at 2,800 during Friday's trade following a mediocre rally on Wednesday that was aborted after President Donald Trump on Thursday publicly criticized the Federal Reserve and Fed Chairman Jerome Powell for hiking rates, which he views as threatening to undo all the positives that tax cuts have done for the economy.

Speaking of Powell, he gave testimony this past week to the Senate Banking Committee and House Financial Services Committee, and was much more dovish than expected, reiterating that he intends rate hikes to be gradual and at a pace of once every three months for a total of two more in 2018. He went on to say the Fed doesn't believe the economy is overheating, wage inflation is only growing at 2.5%, and that there is more room for unemployment to fall.

Hot-button topics, such as Trump threatening tariffs on up to $505 billion in Chinese goods and the continued flattening of the yield curve, continue to dominate the financial media. When asked during his testimony, Powell downplayed the trade war, stating it's uncertain how increasing tariffs will affect the economy.

The increasingly flattening yield curve is starting to worry investors and economists, who warn that the curve will eventually invert if the Fed continues this path of gradual rate increases. With that said, I'd like to note that the yield curve spread of the 10-year Treasury minus the 2-year Treasury is near its year-to-date low of 0.24, increasing slightly on Friday to 0.29. These are the lowest levels since September 2005 when the curve is in a downtrend.

current 10 year minus 2 year yield curve
Chart courtesy of StockCharts.com

So, what does this mean for stocks in the short-to-intermediate term? Well, it turns out not much, at least for a handful of months or more. Indeed, an inverted yield curve has preceded the previous five recessions and will have market participants worried regardless -- but I'd like to point out that this popular recession indicator has been, on average, 15.4 months early over the last five recessions.

yield curve inversion recession signal

We can guarantee investors' behavior will change once the curve inverts, which makes this indicator something of a self-fulfilling prophecy. But we'll see other signals in the market, like the Leading Economic Index (LEI) turning negative and relative strength sustaining a rotation toward defensive late-cycle sectors, before we should be concerned.

"Over the last month, we also saw sector rotation away from technology, financials, and consumer discretionary stocks, into more defensive sectors such as staples, utilities, and REITs. But, in the last few days, we've seen sector rotation happen once again back into technology and financials, with consumer discretionary trailing, but all starting to rebound. We'll want to see continued follow-through in this sector rotation if the market is going to continue to rally here."
-- Monday Morning Outlook, July 16, 2018

Since we're on the topic, relative strength continues to rotate back into mid-cycle leaders like technology and industrial sectors. Also, it was positive to see financials rebound, with the SPDR S&P Bank ETF (KBE - 48.69) positive for five straight days after coming off a major 2018 support area of $46.85. This rotation gives us hope that we can finish out July -- which is typically seasonally strong -- on a positive note before heading into August, which happens to lead off a less predictable market period.

Sentiment data has started to reflect the same confusion as the stock market action, with the latest American Association of Individual Investors (AAII) survey showing bullish sentiment down 8.4 percentage points and bearish sentiment pulling back 4.2 percentage points, as well, while neutral sentiment surged by 12.6 percentage points. The equity-only buy-to-open put/call volume ratio saw a slight decrease and is now at 0.56. This is nearly an opposite scenario of what we saw last week, which tells me this market is searching for a catalyst beyond the break above SPX 2,800.

As for breadth, the number of stocks above the 200-day moving average finished flat with no change from last week, but the ratio of new highs to new lows on the New York Stock Exchange (NYSE) declined to 69.0 after being positive last week at 177.0 -- further indicating that the market is confused and remaining cautious.

nyse new highs-new lows ratio
Chart courtesy of StockCharts.com

"If this keeps up, we have a shot at passing the first quarter's record 26 percent earnings gain. 'These are very strong early results, and it's clear this is a lot more than just tax cuts,' David Aurelio, who follows earnings for Thomson Reuters, told CNBC."
-- CNBC, April 17, 2018

According to data from Thomson Reuters, of the 67 SPX companies reporting last week, 79.1% have beat by 0.9% on earnings. With a lot more earnings on tap this week, we're looking forward to the continued trend of earnings beats and strong guidance. To put this into perspective, we had 193 total companies reporting last week, but this pales in comparison to this week, when we have 817 companies on the earnings calendar.

So, we covered that the markets have positive economic and earnings data, but mixed sentiment data. But, what about the options market? On Friday, 91,117 July 280-strike calls expired worthless on SPY as the market retreated to where it opened on Monday. In the August series, we're seeing high open interest in the SPY 270-strike put options, and noticed increasing volume in out-of-the-money Cboe Volatility Index (VIX - 12.86) call options at multiple strike levels. Now, it's hard to determine if someone is hedging with cheap options or bracing for a correction, but it's something we'll continue to monitor.

spy august open interest by strike

Going into this week, we remain hopeful that July can still finish out as strong as seasonality suggests, and that the cautious attitudes of market participants turn optimistic as long as we hold the current support levels of 2,800 on the SPX and 279 on the SPY. With that said, we'll be on the lookout for any weakness that could potentially send us back into the SPX 2,700 to 2,800 range.

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