August 2, 2018
Markets have staged an impressive uptrend since the March 2009 lows, with the S&P 500 Index up nearly 320% over that time frame. Skeptics have been calling the top since 2010, not long after the rally began. Recently, however, signposts are appearing that may indicate changes on the horizon.
Every market cycle is different. Every bull market ends for different reasons – technology stocks imploding in 2000 and the housing market collapse in 2008 are the two most recent examples. But, despite the differences in how market cycles play out, there tend to be common characteristics visible as the economy transitions from a long growth phase to potential contraction.
Taking a midyear outlook, here are a few things to keep an eye on:
- The yield curve: On June 13, the Fed raised the fed funds rate by 25 basis points, to a range between 1.75% and 2%. They also indicated that two more rate hikes could be expected in 2018. After the decision, the spread between two- and ten-year Treasuries fell to 39 basis points, the narrowest since August 2007. Typically, as economic expansions mature, the yield curve flattens and can invert (short-term rates higher than long-term) as the Fed raises short-term rates to combat inflation. The spread between three month bills and 10 year notes has inverted prior to each of the past seven recessions, but it should be noted that while it’s not guaranteed to happen, it can take one to two years for a recession to develop after the curve inverts.
- Commodities and related stocks: In a rising interest rate environment near the end of an economic expansion, this asset class usually outperforms. Although there have been pockets of strength due to rising oil prices and a weak U.S. dollar, this group has yet to fully break out to the upside (see chart). But if it does start to consistently outperform the broader market, this could be another sign that the late expansion phase is upon us, with a potential recession approaching.
Source – thinkpipes© Platform
- Sector Rotation: At various stages of the business cycle, certain sectors tend to outperform. As the cycle moves from late expansion into early contraction, you typically see the more defensive sectors outperform, such as utilities and consumer staples. As of this writing, the performance of consumer discretionary stocks relative to consumer staple stocks is at an all-time high, confirming investors’ confidence in a strong economy. Nobody knows when that sentiment is going to change, but significant shifts in relative sector strength could provide an early signal that the economic outlook is weakening.
The end of a bull market can feel like a game of musical chairs. No one can say exactly when the music will stop, but investors can use a few key markers to potentially reduce their odds of being left without a seat.
Past performance of a security, strategy, or index is no guarantee of future results or investment success.
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