foxex: Investors Look for Support Despite Yield Curve

Chart Advisor | Focus on the Price

Monday, March 25, 2019

1. Yield curve is a terrible timing signal

2. Semi-conductors lead the selling

3. Investors not ready for hedges yet

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 3-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 is 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 US 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 US 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 (NVDA) and Texas Instruments (TXN). A notable semiconductor analyst at Bernstein Research downgraded TXN (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 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 (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 $2720. 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 remains above support, I would expect the initial bearish price target for the S&P 500 to hold as well.

Read more:

The Impact of an Inverted Yield Curve

Trading the MACD divergence

The Dovish Fed Tightened Last Week by Reducing Its Balance Sheet

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 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.

Read more:

What is the SKEW Index?

A Beginner's Guide to Hedging

Unusual Buying in ETFs Is Growing

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.

Read more:

4 Ways Apple Is Reinventing Itself

Why Bank Stocks On Brink of Bear Market May Plunge Further

Learn the basics of investing

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