Yield Analysis

The market is hitting new highs but we’re still waiting for a better entry point to deploy new capital. We anticipate a pull-back in the market that will offer itself as a buying opportunity. We believe it will be a minor correction and not the start of something worse for several reasons.

The Pullback

The reflation trade is ongoing but needs to take a breather in our opinion. Looking at sector performance over the past 100 days we can clearly see the rally was led by cyclicals tied to an expected economic pickup. Industrials, Materials and Financials have taken the leadership mantle.

That said, over the past several weeks we have seen improvement in economically defensive sectors such as health care, consumer staples and utilities. We anticipate this rotation can have a negative impact on equity performance in the short-term.

This rotation is seen in our economically cyclical vs. defensive index.

Short-term Yield Analysis is worrisome

In addition to the sector rotation trends we have seen, interest rate yield spreads are a reason to raise an eyebrow currently.

The first chart below compares the Moody’s AAA Investment Grade Bond yield relative to the twelve month-forward earnings yield for the S&P 500. This spread should move in the same direction as the stock market to confirm a rally. What we are seeing now is the S&P 500 hitting new highs while the IG/SPX yield spread is hitting resistance. The previous two times this resistance was reached the stock market went into a brief correction. The first time was very minor (approximately 6% from peak to trough) and the second time the S&P 500 dropped roughly 12%.

When comparing the spread between investment grade and high yield bonds, we can see that we are entering a range on the chart that is usually indicative of some market turbulence on the horizon.

The relative price performance comparison between the investment grade ETF (AGG) and the high yield ETF (HYG) is a good test to confirm a market rally. While the trend between the two is down, we are looking for hints of a small reversal. The AGG:HYG price ratio is the lowest it has been in the history of these two ETF’s. We are looking for a reversal that could impact the market in the short-term.

Lastly, we look at the Moody’s High Yield Bond rate relative to the twelve month-forward E/Y for the S&P 500. This ratio should be moving in the same direction as the overall market (SPX). Instead what we are seeing is a major divergence between the two. As the stock market is hitting new highs, the HY:SPX yield spread is moving in the opposite direction. This is not a great sign for the strength of the current rally. Adds fuel to our thesis on a short-term pullback.

On the technical side, we are approaching the top of the upward channel but most market internals just aren’t confirming the market rally. RSI and Stochastics are making lower highs as the market is making higher highs. Volume on the days the market is rallying is soft and MACD momentum is still sloping downward despite a bullish cross last week. The percent of companies in the SPX in bullish P&F formations is making lower lows as is the percent of companies in the SPX trading above their 50-day moving averages. New Highs to New Lows are not confirming the rally nor is the comparison of the SPX to the S&P 500 equal weight index.

All told we will not be crazy enough to short into this market but we are waiting patiently to deploy new investment money if a pullback were to happen. We are confident that a pullback would be quick and shallow in nature and believe the overall bull market will remain in place at least through the end of the year.

Coming Bear Market?

Not yet.

The Federal Reserve Bank of Atlanta publishes their GDP-Based Recession Indicator Index. The latest reading shows a 5.3% chance of a US economic recession on the horizon. The model is trending lower confirming an economic expansion. A reading between 50% and 65% is usually a signal to start worrying about.

Similarly the Federal Reserve Bank of St. Louis releases their Smoothed U.S. Recession Probabilities. They define the index as, “Smoothed recession probabilities for the United States are obtained from a dynamic-factor markov-switching model applied to four monthly coincident variables: non-farm payroll employment, the index of industrial production, real personal income excluding transfer payments, and real manufacturing and trade sales.”

They place the probability of a coming recession at just under 3%.

That said we do believe we are in the very late stages of the economic cycle and thus the market cycle. As the figure below shows we could get new market highs from the reflation trade as Materials, Industrials and Energy lead the pack. This final cycle could very well last into 2018 but at some point, the market cycle will turn.

We track the yield spreads between the two-year and ten-year sovereign debt spreads across the globe. We break it down in three categories; North American developed markets, European developed markets and Asia-Pacific developed markets. We then weight each country’s yield curve by their GDP contribution to the region. Since the US election, global yield curves have been steepening. We believe this ties into our thesis of the reflation trade and higher stock prices this year (see our blog post Investment Thesis for 2017).

The following three charts are the regional yield curves weighted by each country’s GDP contribution to the region.

As the reflation trade ensues and global economic growth starts to pick-up, he Fed and other world banks will need to start raising short-term rates to keep inflation subdued. The market anticipates this action and the market sells off. As the chart below shows, the beginning of a steepening yield curve is a good thing for the stock market. During the steepening yield curve process the market goes on to rally twelve to eighteen months after the start of the steepening cycle.

Global yield curves have started steepening and the stock market has started to rally on expectations of pro-growth, simulative policies that could spur economic growth. Should these expectations become reality then the yield curve steepening cycle should continue and the stock market could see another twelve to eighteen months of gains.

The one difference this time around is that the US yield curve never was inverted. It did come close but the use of unorthodox monetary policy measures (Quantitative Easing and Operation Twist) after the Great Recession could have skewed the results.

The primary reason for the market corrections are due to Fed policy and their mandate to fight the effects of inflation and keeping a stable currency. As the Fed starts to tighten in the later stages of the economic growth cycle, this starts a new flattening cycle but by then the damage is already done for equity investors.

One key variable to watch over the next year is inflation expectations. With the reflation trade in full swing, it would make sense for inflation expectations to become more elevated than in recent years past. This would confirm the onset of a possible bear market in the future.

Tracking the spread between the 10Y TIPS and the 10Y US Treasury yield is a way to look for potential problems.

Another tool to use in watching credit spreads is the LEI Leading Credit Index. From the Conference Board website, “This index is consisted of six financial indicators: 2-years Swap Spread (real time), LIBOR 3 month less 3 month Treasury-Bill yield spread (real time), Debit balances at margin account at broker dealer (monthly),  AAII Investors Sentiment Bullish (%) less Bearish (%) (weekly), Senior Loan Officers C&I loan survey – Bank tightening Credit to Large and Medium Firms (quarterly), and Security Repurchases (quarterly) from the Total Finance-Liabilities section of Federal Reserve’s flow of fund report. Because of these financial indicators' forward looking content, LCI leads economic activities.”

A sharp rise in the year-over-year growth figure for this index usually represents tough economic times ahead. When this index starts showing 10% y-o-y acceleration, it’s usually time to start protecting your portfolio.

Bottom Line: We believe short-term yield analysis is confirming our thoughts of a near-term brief and shallow pullback. We will use this opportunity to deploy new assets as we believe the reflation trade and steepening yield curve offers additional upside to the market this year. We will be watching our yield spreads for further confirmation or rejection of our thesis.

Joseph S. Kalinowski, CFA

 Email: joe@squaredconcept.net

Twitter: @jskalinowski

Facebook: https://www.facebook.com/JoeKalinowskiCFA/

Blog: http://squaredconcept.blogspot.com/

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