Investors Look for Support Despite Yield Curve

0
84

Major Moves

I suspect that the back and forth trading today is still the result of the negative signals produced from the bond market last week. As I mentioned in last week’s Chart Advisor, the yield curve finally inverted on Friday. Specifically, the 10-year Treasury yield dipped below the three-month Treasury yield. Historically speaking, this has been a harbinger of recessions.


As reliable as this signal has been in the past, it is terrible for precise timing. The last inversion occurred in 2006, and the market didn’t drop into very bearish territory with a recession until 2008. That was a longer-than-average lead time for this signal, but prior examples have still been measured in months rather than weeks or days.


Financial stocks tend to underperform when interest rates are in decline or the yield curve is inverted – however, that sector is probably not going to be the focus of the greatest losses if investors continue to worry about another correction in the short term. Emerging markets (EM) are in the worst position because so many regions within that category are already showing signs of slowing economic growth.


Because EM are in such a precarious position and the rally in EM stocks has been so robust this year, I am watching this sector for breakouts that will serve as an early warning for greater weakness in U.S. stocks. In the following chart, I have used the iShares Emerging Markets ETF (EEM) as a benchmark. If EEM breaks below support in the $41.70 range, then I think greater concern for U.S. stocks is warranted. However, if EEM confirms support and moves higher, as it did in December, then I believe traders should take advantage of the opportunity to look at stocks at lower prices while we wait to see how the interest rate environment settles.



S&P 500

The S&P 500 was led lower today by tech and basic materials stocks. The losses in the tech sector were distorted by outsized negative performance in Apple Inc. (AAPL) and concentrated selling in semiconductor stocks such as NVIDIA Corporation (NVDA) and Texas Instruments Incorporated (TXN). A notable semiconductor analyst at Bernstein Research downgraded Texas Instruments stock (and therefore the entire sector) after concluding that semiconductor stocks may not recover in 2019 as originally expected.


On the bright side, industrials and homebuilders were higher today, which indicates that investors aren’t ready to move completely into safe havens yet. Several homebuilder stocks report earnings in late March and April that could give us some important insight into consumer and industrial sentiment. While I wouldn’t normally put this much emphasis on an earnings report from Lennar Corporation (LEN), the homebuilder, it will be reporting on Wednesday before market open, which could serve as a turning point for stocks in the short term if new orders are higher than expected.


From a technical perspective, the S&P 500 completed a bearish MACD divergence last week that has an initial price target at the midpoint near 2,720. That would be within normal volatility ranges and could serve as a support level that coincides with a few upcoming earnings and economic reports. If EM remain above support, I would expect the initial bearish price target for the S&P 500 to hold as well.











Risk Indicators – SKEW

Although there are several longer-term indicators signaling a cautious market, the CBOE SKEW index has been surprisingly bullish. For example, although stocks on Friday were rapidly declining, the SKEW index also fell to longer-term lows. Because the SKEW rises with investor fear and falls with investor confidence, I feel that it supports my view for support to hold in the near term.


Like the CBOE Voatility Index (VIX), the SKEW is calculated from option prices on the S&P 500 cash index. The formula focuses on the relative price of out-of-the-money put options that are used to hedge against large market declines. As you can see in the following chart, the SKEW was elevated in August-September of last year as investors were hedging in front of the big decline that began in October.


According to the analysis I have done on the SKEW, its most valuable signal is when it is doing something contrary to the market. If the SKEW is rising quickly with stocks, it is more likely that a correction is coming. However, if the SKEW is falling with stocks, it is likely that support will hold in the short term and prices will rise. Nothing is 100% – however, I have found this signal to be an important one to put risk in perspective. Even if stock prices continue to fall this week, I would still suggest investors watch for a new buying opportunity in the short term.











Bottom Line: Look for Support

Expect to see a lot of stories over the next two weeks about the disagreement between analysts who are worried about the yield curve and those who are confident that “this time it is different.” At this point, I am still a little undecided about how fearful investors should be about a recession. However, what we know from historical data is that, even if a recession appears following an inversion, it takes time to form, and that gives investors more opportunities to profit in the meantime.










Enjoy this article? Get more by signing up for the Chart Advisor newsletter.




Original Source