QQQ - The Risk Of A Stock Market Top In July

2023-07-05 12:49:02 ET

Summary

• Yes - the odds do favor the bulls broadly because it's a pre-election year, but that doesn't mean there isn't risk.
• The inversion of the yield curve has traditionally been a reliable predictor of recessions.
• While history has shown December is typically when the year's high for the S&P 500 takes place, there is a distinct possibility the year's top for equities happens this month.

The secret to humor is surprise. - Aristotle.

As we navigate through the second half of the year, the U.S. economy appears to have found some semblance of stability, albeit at a slow pace. Recession calls have been delayed, and everyone is on the melt-up train (at least in narrative). Yes - the odds do favor the bulls broadly because it's a pre-election year, but that doesn't mean there isn't risk. And if history is any guide, there's a not-so-small chance that stocks peak in July for the year.

The Shadow of Recession

While earlier predictions indicated a significant U.S. recession in 2023 or 2024, the tone has softened. However, the risk of recession hasn't disappeared entirely. If anything, the term structure is screaming for it. Looking at the 10-year minus the 2-year, we are at biggest differential since 1981. While not a perfect indicator (because one does not exist), this is a major warning sign that we are still at high risk of an economic accident.

Could this be what marks a near-term top for the S&P 500 ( SPY ) and the NASDAQ 100 ( QQQ )?

The 10-2 Spread: A Crucial Economic Indicator

The 10-2 spread, the difference in yields between the 10-year and 2-year U.S. Treasury bonds, is a key indicator closely observed by investors. Under normal conditions, the 10-year bond has a higher yield than the 2-year bond. However, when the 10-2 spread goes negative, or inverts, it's often viewed as a warning signal for the economy.

Each of the past seven U.S. recessions has been preceded by an inversion of the 10-2 spread. However, it's important to note that while every recession since 1960 has been preceded by a yield curve inversion, not all yield curve inversions have led to a recession. Therefore, while an inverted yield curve is a strong indicator, it's not an absolute predictor of an economic downturn.

The Yield Curve as a Recession Predictor

The inversion of the yield curve has traditionally been a reliable predictor of recessions. Historically, there has been a greater than two-thirds chance of a recession occurring within the next year when the yield curve inverts. In the past, recessions have started an average of 19 months following a yield curve inversion. Therefore, while an inverted yield curve is a useful tool in predicting potential economic downturns, it doesn't provide a precise timeline for when these downturns will occur.

This isn't about being a perma-bear by any means, but to deny the fact that interest rates act with long and variable lags in the context of the fastest rate hike cycle in history seems misguided to me.

Conclusion

While history has shown December is typically when the year's high for the S&P 500 takes place, there is a distinct possibility the year's top for equities happens this month. That does not mean stocks have to go down substantially even though I believe a credit event is out there. This is about probabilities and path behavior. Yes the odds do favor the bulls into year-end, but markets oftentimes surprise the crowd.

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