2023-07-27 07:40:59 ET
Summary
- The inverted yield curve, which usually signals a recession, hasn't produced one yet, and a bull market seems to have started without the normal transition to a steep yield curve.
- This caught many investors and advisors on the wrong side of the market, and many are now becoming bullish and going with the trend.
- Despite current bullish sentiment, the unresolved economic situation could indicate that we are not in a new bull market but have started a large, trading range market that could last four years.
- But what's the evidence?
Most are aware that an inverted yield curve portends a market top and an impending recession. Few are aware, however, that the opposite - the movement from the inverted curve to a steep positive curve - has historically signaled the start of a bull market.
In the current market, both conditions failed. The inverted curve hasn't yet produced a recession, and a bull market seems to have started without the transition to a steep yield curve.
We believe we know what this means, but let's first look at a little history.
The Inverted Yield Curve
Positive and negative yield curve versus the S&P 500 (Sentiment King)
This chart shows in red the difference in yield between the 10-year treasury and the two-year treasury. It's plotted against the S&P 500. This curve is used by the Federal Reserve as a leading indicator and has appeared in many SA articles.
Yields are inverted when the red curve goes below the black line. It means short-term rates are higher than long-term rates. It's easy to see that inverted rates almost always precede a recession and a bear market. Recessions are highlighted in grey.
The green arrows indicate the starting point of the following bull market. Notice that bull markets almost always start after the yield curve has reversed and gone positive again, usually quite positive.
The orange arrow points to the current situation. Not only is the curve heavily inverted and has not yet produced a recession, but we also appear to have started a new bull market without the transition to a positive curve.
Trend Followers
This caught many investors and advisors on the wrong side of the market and, after an eight-month rally, they're throwing in the towel. They're becoming bullish and going with the price trend. Just yesterday, the main strategist at Morgan Stanley did an about-face and finally turned bullish.
But this puts them into a difficult situation as it leaves everything unresolved. Was their thinking all wrong? It's also very difficult for them to become bearish again if the negative conditions prove right and prices start declining. They get whipsawed, both financially and emotionally.
Fortunately, we don't have this dilemma, since we've been bullish since last autumn. We ignored the economic picture and based our bullish position simply on the theory of contrary opinion, stating that the market was ready to advance simply because so many people thought it would fall. In fact, in a December article , we wrote:
This moment, therefore, represents a wonderful test of the theory of contrary opinion. It highlights this question:
What's more important in the determination of stock prices: all the negative economic reasons people are stating on why the economy is moving into a recession and why stock prices will go lower; or the simple fact that so many people believe this. If the theory of contrarian is universally correct, then this in all likelihood won't happen.
Only time will tell. We'll visit this article one year from now to see how this all settled out.
Well, it turned out pretty good. And since we've been bullish over the whole advance, we think we're in a much better position to evaluate this unresolved situation. This is also made easier by the growing bullish sentiment since this will allow us to freely turn bearish if conditions warrant.
The Unresolved Economic Situation
We think the negative yield curve and a bull market starting without a positive yield curve are important and are telling us something. This, coupled with investor concentration in a few, heavily capitalized technology stocks, plus the growing bullish sentiment as we approach past highs, are all indicating that we are not in a new bull market but have started a large, trading range market that could last four to five years.
The best example of what we expect to happen is shown in the chart below. It's a graph of the 1969-74 market. The chart is the Dow Jones Industrials plotted against the advanced decline line. What many think as two bear markets were really two down waves of a large, six-year correction.
The 1969 to 1974 Dow Jones Industrials versus the A-D line (Sentiment King)
The red line highlights the two market tops in the Dow - one at the beginning of 1969 and the other at the beginning of 1973. It was the narrow performance of 50 large stocks, called the nifty 50, that drove the Dow to the high in 1973.
The A-D line shows the price pattern of most stocks at the time. The blue line highlights the long downtrend in most stocks over the six-year period. This divergence was the prelude to the second wave down in 1973-74. We believe we have a similar situation today.
Although the conditions that created this market were different from the current situation, we believe the outcome will be similar.
Trading Range Forecast
Over the next three or four years, we believe we are going to experience something like what is diagrammed below. In our opinion, this forecast fits with the conditions we've just outlined. The diagram speaks for itself.
Diagram of the Trading Range Forecast (Sentiment King)
Unfortunately, economic data won't be as useful in forecasting this type of market, just like it wasn't useful at predicting the current advance. The most valuable tools will be those based on investor expectations and contrary opinions.
It also means that investors can't fall in love with the trend as they have in the past. They are going to have to be more flexible.
One factor investors should carefully watch is whether the advance begins to broaden out to more sectors besides technology. If the market continues higher and 80% or more of S&P sectors make new highs, that would be a sign this forecast is definitely wrong and the failed inverted yield curve was simply an isolated anomaly.
For further details see:
The Missing Yield Curve Buy Signal