Fri, Apr 1, 2022|Corey McLaughlin

Here's What to Make of This Market 'Warning Signal'

The trouble with the 'yield curve'... Here's what to make of this market 'warning signal'... It's happened 11 out of 12 times... The same thing, but worse... What does this mean for stocks?... Prepare for more rocky times ahead... A financial survival guide...

Perhaps you've heard about a certain 'recession indicator' this week...

If you haven't, let me (Corey McLaughlin) begin by trying to get everyone up to speed as quickly as I can...

It's a warning we've talked about here before, as recently as a few weeks ago... but it has been getting more play in the mainstream financial media this week.

I'm talking about the "inverted yield curve," which has typically been an early sign that trouble (can you say "recession"?) is ahead for the U.S. economy, and, by association – most assume – the stock market.

In today's Digest, we'll explain what and why this is... and then get into what we make of the latest "inversion"... because it is significant. The media has that right.

But, as with anything, there is a good amount of relevant detail to discuss about this market feature that you likely won't hear elsewhere, so we will do that here.

We'll also end today with some good news... about what several of our editors are doing to make sure all Stansberry Research subscribers are prepared to navigate the rocky road that this "recession indicator" typically portends.

So, let's get right to it...

Our DailyWealth Trader editors Ben Morris and Drew McConnell did a fantastic job earlier this week discussing what they described as a "major warning sign for stocks"...

As they wrote in their Tuesday issue...

The last three times this happened, painful bear markets followed... And signs point to it happening again in the near future...

The warning we're talking about is an interest-rate "inversion" – a rare situation in which short-term interest rates are higher than long-term rates.

Specifically, they were talking about the difference between the interest rates on the two-year (short-term) and 10-year (long-term) U.S. Treasurys, or government bonds, as lot of folks refer to them.

Now, before you say, "You mean you're about to talk about boring old bonds... really?" and head for the exit button, please hear us out. This is important.

Grasping this concept can go a long way to helping you see and understand general trends in the economy and with the markets at any given moment, not just today.

As Ben and Drew wrote...

When you buy a Treasury, you're loaning money to the U.S. government. And normally, the government needs to pay you a higher interest rate to tie up your money for longer amounts of time.

If, for example, the U.S. pays 1% per year on a two-year loan (a two-year Treasury), it might have to pay 3% per year on a 10-year loan (a 10-year Treasury).

This is the natural order of things because the risk of any loan increases with time... You might think you have a reasonably good idea of what's going to happen over the next year or two. But you don't have nearly as good of an idea of what the world will look like in 10 or 30 years...

Will the U.S. still be the dominant world superpower? Will the U.S. dollar still be the world's reserve currency? Will inflation be at 1% or 10%?

In other words, more time means more uncertainty. And more uncertainty equals more risk. So, as Ben and Drew wrote...

Investors should demand a higher interest rate to compensate for higher risk.

Once in a while, though, yields invert – short-term Treasurys like the two-year yield more than long-term Treasurys like the 10-year. It shouldn't happen, but it does. And it's a clear sign that something is amiss in the markets.

As Stansberry NewsWire editor C. Scott Garliss wrote in his Wednesday morning market preview, the U.S. two-year yield briefly exceeded the 10-year yield on Tuesday for the first time since 2019.

And this "inversion" followed market action on Monday that saw another telling yield-spread invert, when the five-year Treasury yield traded above the 30-year Treasury yield for the first time since 2006.

This is indicative of larger uncertainties about risk in the market...

The bond market is huge, and these sort of funky yield things don't happen overnight. They happen slowly, like a "turtle race," as we put it earlier this year. And, as Ben and Drew wrote, these behaviors in the bond market tend to proceed painful market drops...

The 30-year chart below shows the "yield spread" between the 10-year and two-year Treasurys. That is, it shows the yield on the 10-year Treasury minus the yield on the two-year Treasury. When the yield spread drops below 0%, yields (or rates) are "inverted."

The bottom section of the chart (in blue) shows the benchmark S&P 500 Index. As you can see, not long after the yield spread inverts, stocks drop...

The last four times the yield spread between 10-year and two-year Treasurys crossed below 0%, stocks dropped an average of 40% soon after. And [Monday], the spread fell to just 0.12%... It's getting awfully close to 0%... and then an inversion.

As of yesterday's close, the spread was 0.04%. Today it closed at negative 0.06%.

I'm going to 'get in the weeds' for a moment...

Frankly, feel free to skip ahead to the next heading if it strikes you... but we want to share some details we haven't seen published elsewhere.

As of today's close, we've actually seen "inversions" in the 5-3 year Treasury spread, the 7-3, 10-5, 10-3, 10-2, 30-20, 30-5, and maybe most notably to me, the 30-3, meaning you could get a better yield on a three-year Treasury (2.58%) than a 30-year note (2.44%).

That's not "normal," and shows that the "smart money" in the bond market is as uncertain about the next three years as the next 30... Woah.

The only Treasury-yield relationships that aren't that close to inverting are those that include one-year notes or shorter, like the three-month/10-year spread... and that's because the Federal Reserve has much more influence over short-term rates than longer-term rates...

But the point is, things are already getting funky with the 'yield curve'...

And when we've seen this kind of behavior before, stock market sell-offs – particularly the last several major ones Ben and Drew mentioned – have followed. But why?

Well, almost every time the yield curve has inverted – dating back to the 1950s – a recession has followed. By almost every time, I mean 11 out of 12 times, with only one false positive...

But here's another very important point if you're wondering about the timing of all of this. In these instances since 1955, the recession has occurred within six to 24 months after the initial "inversion"...

Not tomorrow. Not next week. Not even next month... But, on average, about 19 months later.

So, yes, this is an indicator you should pay attention to. But you should also know the details. As our colleague Dr. Steve Sjuggerud wrote in his DailyWealth newsletter back in September 2019...

The financial media, and most investors, believe an inverted yield curve is the sign that the end is near. And ultimately, it is.

However...

The yield-curve inversion is actually a major bullish sign for stocks in the near term.

Steve went on to note that the previous three times the yield curve inverted, the market didn't peak for another 18 months... each time. And stocks gained 21% on average.

And then the last time 'this' happened...

What will most likely be forgotten in much of the history written about the "COVID-19 crash" (but not here!) is that the yield curve "inverted" six months earlier, in August 2019.

We wrote about it in the Digest, much like we are today, and said this was a "warning signal" – we didn't know what it would ultimately mean – but it was worth noting for all the same reasons we're talking about today.

Considering at the time many people were talking about the "longest bull market of all-time" and wondering how it would end, the bond market was signaling it might be ending soon...

After all, inverted yield curves almost always predict recessions, and recessions often coincide with bear markets...

But it took time, as it has recently. The S&P 500 Index gained roughly 16% in the six months between the yield-curve inversion of August 2019 and what would become known as the "COVID-19 crash."

Now, we didn't know a once-in-a-century (we hope) pandemic would be the trigger for a simultaneous crash and brief recession, but if it wasn't, the point is something else would eventually slow the economy... and take some air out of asset prices.

The most likely bet was on the Fed eventually raising interest rates again because of record-low unemployment, and low inflation. These were the under-2%-inflation days, at least by "official" numbers, which was most of the previous decade.

Nearly three years later, it's the same thing, in worse conditions...

The Fed is hiking rates and pulling back on stimulus efforts – which would slow an economy in any circumstances, but now inflation is at decades-long highs... the Fed's balance sheet is twice as large (near $9 trillion)... and U.S. debt-to-GDP is well above 100%.

We're not going to argue that people didn't need financial help during a pandemic. And as a "money issuing" nation of the world's reserve currency, the U.S. had the means to issue trillions of "out of thin air" money.

But from an economic standpoint, all the money the U.S. government printed amid the pandemic ‒ and the inflation that's followed ‒ looks like it could trigger a longer recession a year or two from now... if you believe the past performance of the yield-curve indicator.

In the meantime, asset prices in general have soared higher... Like before the pandemic, unemployment is also low today, mainly because people left the workforce entirely for various reasons during the pandemic.

So, some things about today are different, but some are the same. Now that the dust has settled on the pandemic in the U.S. at least – although no one has said it yet – we actually see that a lot is the same...

There's a lot more we could and want to get into about this story – like how oil "shocks" have been an even more reliable predictor of recessions than the yield curve – but let's get closer to the finish... and we'll continue with this another day.

'What does this mean for my stocks?'

Great question. All in all, funky bond-yield curves typically mean enough folks with money in the markets are expecting "something wicked this way comes" for the economy... like a recession.

But it doesn't mean a recession is imminent. And here's the other part to consider... and a prime example of why the "economy is not the stock market," as our colleague Kim Iskyan has written before.

By the time there's enough data to officially "call" a recession – many people consider it two straight quarters of GDP decline – slower growth has already hurt companies and everyday Americans for at least six months, or two quarters.

Only then does everyone realize or say in public... "We're in a recession." Much like inflation has hit the wallets of millions of people for at least a year, the effects of a recession are felt long before anyone in Washington, D.C. or anywhere else starts making speeches about them...

Meanwhile, Mr. Market is forward-looking, with prices fluctuating based on current values and future expectations. Or at least the "smart money" in the market is forward looking...

That goes for folks buying or selling stocks and bonds and any other asset over the long term. On balance, over the past few months, Mr. Market has been pricing in lower "growth" ahead... That's why stocks are down this year.

Market tops are most obvious in hindsight, unfortunately...

And when we look back at things today, it looks like market "breadth" – in this case, I mean that the number of stocks on the New York Stock Exchange trading above their 200-day moving averages – peaked back in early to mid-2021.

This is when many "growth" stocks peaked... and started selling off, like the ones that make up many of Cathie Wood's ARK Invest funds. Our colleague Dan Ferris nailed the peak in those funds almost to the day with a Digest last February.

Of course, the major U.S. indexes were still hitting new all-time highs, as of November of last year, but then things started to get worse as the Fed's rising-interest-rate plans became real... Volatility kicked into high gear and hasn't stopped.

The analogy that our colleague and Ten Stock Trader editor Greg Diamond made between the dot-com bubble and today has continued in tech stocks... So has the "rolling crash," as our friend and Chaikin Analytics founder Marc Chaikin describes it.

And today, the "safer" government bond market is now expressing concerns, via higher short-term rates than longer-term rates... that typically proceed a recession. But, important to know, not one that happens right away.

This is all to say, yes, you should be prepared for rocky times ahead...

It doesn't mean the entire stock market is crashing immediately just because parts of the yield curve have inverted, but it does mean there is more room for downside than upside ahead... Make sure you are prepared.

Greg sent his subscribers another warning to that point just today. And as Scott wrote in the NewsWire today, the recent market rally – the S&P 500 up 8.6% and Nasdaq up 13.1% in just two weeks – is showing signs of exhaustion.

In general, in environments like today, you do want to be more discerning about what you do with your money than you would in a surefire bull market. It's likely that none of this is too new to you...

That's why we've warned about potential "stagflation" back in January, even before the war in Eastern Europe stoked slower-growth/higher-inflation fears even more...

It's why we've talked about how the "60/40" conventional stock-bond portfolio – that so many folks rely on to "do the same old thing" – has been in real trouble this year... and why you might consider one of the alternatives that we offer.

It's why we've urged folks to consider proven inflation hedges like gold and to own high-quality stocks that can reward shareholders no matter what happens next.

It's also why several of our editors are working behind the scenes right now to put together a special course featuring different strategies that everyday investors can use to protect – and even pad – their portfolios in a recession, a bear market, or any market.

We're calling it the "Financial Survival Guide." This course will touch on a lot of things we've mentioned here over the last few weeks, but our editors are going more in depth and offering actionable insights and recommendations... and even an all-new portfolio.

Stay tuned. I'm excited to share the details with you in the weeks ahead.

Jim Rickards: A Recipe for a Recession

Best-selling author Jim Rickards joins our editor-at-large Daniela Cambone for a wide-ranging interview and explains how the Fed is really "quadruple tightening" and why that is a recipe for a recession...

Click here to watch this video right now. For more free video content, subscribe to our Stansberry Research YouTube channel... and don't forget to follow us on Facebook, Instagram, LinkedIn, and Twitter.

New 52-week highs (as of 3/31/22): MP Materials (MP).

A quiet mailbag heading into the weekend... Nobody even tried to stump us with an April Fools' Day joke... As always, let us know what's on your mind (or if you have a good joke) by sending an e-mail to feedback@stansberryresearch.com.

All the best,

Corey McLaughlin
Baltimore, Maryland
April 1, 2022