Tops, Corrections and Crashes – 4 Early Warning Indicators that Lead
On this week’s episode of Stock Talk, join Chris for a review of “4 early warnings signs” that we monitor for future tops and corrections in the equity markets.
Chris Perras: I’m Chris Perras, chief investment officer at Oak Harvest Financial Group. We’re an investment management and retirement planning advisor located here in Houston, Texas. Welcome to our October 22nd Stock Talk podcast, keeping you connected to your money. Well, last week in our first YouTube video with Oak Harvest investment series, I covered four of the real-time data series that have led strong S&P 500 rallies this cycle. There might be more market-based data series that help you. I welcome your thoughts, but these are the four things we covered.
First, the euro-yen currency pair. Second, Bitcoin pricing. Third, future volatility pricing. Fourth, retail investor sentiment. These four series are just a few of the ones our teams uses here at Oak Harvest. You heard that right. We don’t pay much attention to most of the government-released economic data. We find that it is generally stale, unreliably revised, and not predictive, either the economy or the markets.
People often ask our team, “Chris, James, Troy, what is your crystal ball thing?” They asked this question with a jokingly tone. Some advisors on TV say, “Hey, I don’t have a crystal ball.” However, I believe that all investors need some sort of crystal ball. By crystal ball, I mean forecasting tools, I mean the ability to have an informed, educated view of what might be coming in the future for the markets in the economy if you’re going to invest in equities actively.
Remember, it will never be a perfect vision of the future, but investing in equities is all about the future. The future is inherently uncertain, but the future of equities is about the future of their revenue growth, their future earnings growth, and future dividends. While no one’s crystal ball or forecasting tools are perfect, you should have some consistent tools to help you develop an informed opinion and help you make imperfect decisions on the path of an always uncertain future, which brings me to this week’s podcast title, things that lead, early warning signs and tools, and calling tops, corrections, and crashes.
Yes, you heard that title correctly. Think of this as the second in this series on the things that lead topic. For almost 18 months now, X a few brief four to six-week periods, the investment team at Oak Harvest has been very positive on equity markets. Even during those brief periods of market weakness, we held to our positive market outlook. For 18 months, clients and prospects have asked us if we were bothered by certain news stories.
They asked about COVID wave too, the COVID Delta wave, a contested presidential election. More recently, they asked about the China Evergrande real estate story. They asked about global supply chain disruptions. On the economic front, they’ve asked about peak economic growth. Lately, it was accelerating inflation they’re asking about. More recently, it’s been higher energy prices and stagflation concerns. Consistently, we said, “No, not really. Those things shouldn’t matter yet.”
Why? Because the things that really lead that lead the equity markets by quarters and sometimes by years have said, “We’re in the early to mid-innings of the stock market rally.” Now, after 18 months, well, now, we’re most likely entering the post-seventh-inning stretch. We figured that now is a great time to present three or four things that have historically been good early warning indicators of the coming peak or top that can, though they may not necessarily, finally be present and cause a 10% correction or more.
You’ve probably seen or heard most of these data series many times on TV already. Why? Because the bear camp pulls them out as soon as the data pivots negatively to a new trend. Most of these bears then post them endlessly on the internet, and then they hit the TV contributor circuit pretending doom for equity holders. However, what they almost never tell you is that, historically speaking, these data series are not coincident indicators. They are not immediate red flags. No, they’re more like slow flashing yellow warning lights.
These indicators tend to get the countdown started, but they also may take a long time to work. Think about a range of nine months to two years. As we’ve seen throughout most of 2021, the markets can march much higher even with these early warning signs flashing yellow. Here we go. Four signs that have historically preceded market tops and corrections and occasionally crashes.
The first early warning sign, stock market breadth. Since April or May of this year, research notes throughout Wall Street have been littered with warnings ranging from cautious to outright bearish on the markets because the breadth of the market has been trending lower since the late second quarter by their accounts. I want to first remind everyone what we talk about when we talk about breadth of the market.
What technicians and strategists mean when they talk about breadth is they’re trying to quantify how many stocks or what percentage of stocks in a given index are participating in the market’s up move or down move. In its simplest form, it’s just the ratio of the number of stocks advancing or the number of stocks that are green on your screen to the number of stocks declining or red on your screen.
Improving breadth is good while declining breadth is bad in the bear camp’s black and white world. I remind listeners, peak and lower-trending breadth is almost never a coincident indicator of significant market tops and corrections. Looking back at the first half of 2021, market breadth peaked way back in mid-March. Looking even further back in time, we would see the market experienced a significant breadth thrust in April of 2020.
That’s when market breadth peaked just after the COVID bottom. You see here on the chart behind me, which is publicly available on stockcharts.com right here, that the breadth of the market for the current rally peaked way back in June of 2020. Historic data compiled by Oppenheimer shows that market breadth is not a coincident indicator. What the data shows is that breadth, in fact, has peaked a full two years ahead of the price of the S&P 500 since 2013.
In fact, the facts are, the S&P 500 rallied another 45% between the 2013 breadth peak and the 2015 price peak. Then, once again, another 35% between the 2016 breadth peak and the 2018 price peak. You want to sell stocks on a peak and deterioration in market breadth based on that data? If so, you sold the S&P almost 18 months ago at around 3,200 on the S&P 500. That was over 40% lower than where the current market sits.
If we conservatively take early June of 2020 as the peak in breadth this cycle and assume it was taken almost two years for the market to be affected by deteriorating breadth, well, this would put any concerns due to market breadth from our team somewhere in the first quarter of 2022 to the third quarter of next year. The clock is ticking, but it still looks way too early to worry about this timing indicator.
Our ETW, estimated time to worry, for this indicator call it mid-first quarter of next year. Our second early warning sign, the interest rate yield curve direction. By that, I mean, is the yield curve steepening or flattening? Remember, one of our Goldilocks signs that we talked about for the last three years has been a steepening yield curve caused by gently rising long-term interest rates. In technical financial terms, it’s called “bull steepening.”
Post-great financial crisis hitting in 2008, 2009, rising rates have benefited, have not hurt the US stock market performance. The data doesn’t lie. I know it sounds contrary to almost everything you hear on TV, but slowly rising long-term interest rates have been positive for the overall stock market. This cycle, the S&P 500 has posted an average price return of 15.3% during periods of increasing year-over-year interest rates of the 10-year Treasury bond compared to just a 6.5% gain during periods of falling long-term interest rates.
In fact, some of the strongest returns for the market have occurred when the 10-year Treasury yield rises from below its three-year level to higher levels. Yes, you heard that right. Once again, during rising long-term periods of interest rates, their three-year average, the S&P 500 registered a 16.4% gain. Conversely, in an inversion of the yield curve in which short-term interest rates exceed long-term rates, it’s typically associated with a recession in the near future.
By near future, I define that as 18 to 24 months with a lead time being very inconsistent. With that in mind, a yield curve inversion has preceded each recession for the past 50 years. That being said, data compiled by Credit Suisse shows that the market has rallied on average another 15% in the 18 months following the initial inversion with the recession hitting on average 22 months after the inversion.
The typical pattern is this. Yield curve inverts, the S&P 500 goes higher and tops some time after the curve inverts, and then the US economy goes into recession six to seven months after the S&P 500 peaks. Well, where do we sit now? The yield curve sits around a positive 115 basis points. This is far above the zero line and it currently is a general uptrend. Those are both bullish. This forecasting tool’s estimated early warning time is– Well, its ETW is no recession this year or next.
I think we can still relax on this one. Our opinion is that anyone you hear on TV throwing the R-word around is literally making stuff up based on the data we see and based on history. Our third early warning sign, credit spreads on high yield and junk bonds. Now, junk bonds are a great proxy for foreshadowing investor confidence because to buy them, investors have to be confident that the economy is strong enough to enable the companies that are issuing these bonds to pay them back in the future.
Remember, the best-case scenario for any bond investor is this. You get 100% of your money back and some interest along the way. That’s it. You get your money back and a little reward along the way. That’s your reward for lending money to even the riskiest companies in the market. These bonds, however, have higher yields because they are also greater credit risk and have a higher probability of default. If the economy slows and weakens, opportunities for business to secure funding begin to become scarce and the competition for money increases.
The ability of high-debt companies to pay their debts diminishes. These conditions mean that more companies tend to hit worst-case scenarios more often when the market experiences stress. Bond investors are aware of this. They’re risk-averse. Fixed-income investors sell bonds in their portfolios with the highest risk first. These are junk bonds and less credit-worthy companies. This means that junk bond prices tend to peak and decline six to nine months in advance of their equity counterparts.
One can see from the JNK-ETF chart right here, which represents the junk bond market, that that price has recently peaked out and is beginning to look much like the pattern in October of 2017. Did this foretell the first quarter 2018 sell-off post, the Trump tax cuts? It looks that way to me. Our team is on high alert as this indicator is real-time and rarely if ever wrong for long. What’s this indicator’s estimated warning time? Mid-first quarter of next year.
Our fourth and final early warning indicator, oil and energy prices. Now, this is an interesting one for me that I think few investors have looked at. When I looked at the data over the last 30 years, I found that when energy stocks and, more particularly, when old-line energy gas names and oil names have been amongst the leadership groups in the market, the markets are usually on a very short leash.
Few investors recall that even during the internet bubble in 1999 through 2000, one of the only stock sectors that held its own against energy stocks were energy names like EOG Resources and Apache, whose stocks rose almost 75% to 100% during the last 9 to 12 months of the internet boom. Even Schlumberger’s stock rose over 75% in the nine months leading up to the tech bubble bursting after March 23rd, 2000.
Given old-line energy names’ large year-to-date outperformance versus the markets, our early warning signal is on high alert much like the junk bond indicator. The early warning system places increased risk in the mid-first quarter of next year. There they are for you. Four early warning data series that you can follow if you desire. Two of them are already flashing yellow for mid-first quarter of next year.
Are we changing our outlook currently because of these factors? No, but we do want to preview that our outlook for the majority of 2022 after, say, January or mid-February of next year is likely going to be titled something like Curb Your Enthusiasm. We’ll be covering our first half 2022 outlook in the coming months in detail. For now, we think it still looks and acts like a bull market for equities, albeit having exited the seventh-inning stretch. At Oak Harvest, we think our clients are best served by us helping them with their future needs and risks instead of dwelling on the past.
Our crystal ball is far from perfect, but we like to keep you up what it’s saying about the uncertain future, not about rehashing what’s already known about the certain paths. At Oak Harvest, we’re a comprehensive financial planning advisor located in Houston, Texas. Give us a call to speak to an advisor and let us help you craft a financial plan that meets your retirement goals. Call us at (877)-896-0040. We’re here to help you on your financial journey into and through your retirement years. Many blessings, stay safe, and have a great weekend. I’m Chris Perras at Oak Harvest.
Voice-Over: All content contained within Oak Harvest podcast expresses the views of the speaker and is for informational purposes only. It is based on information believed to be reliable when created, but any cited data, indicators, statistics, or other sources are not guaranteed. The views and opinions expressed herein may change without notice. Strategies and ideas discussed may not be right for you.
Nothing in this podcast should be considered as personalized investment, tax or legal advice, or an offer or solicitation to buy or sell securities. Indexes such as the S&P 500 are not available for direct investment and your investment results may differ when compared to an index. Specific portfolio actions or strategies discussed will not apply to all client portfolios. Investing involves the risk of loss and past performance is not indicative of future results.
CFA®, CLU®, ChFC®
Chief Investment Officer, Financial Advisor
Chris is a seasoned investment professional with over 25 years of experience working with some of the most successful money management firms in the world. Chris has made it a point in his career to adapt as the market landscape changes, seeking to utilize the appropriate investment strategy for a given market environment. His transition from managing billions of dollars at the institutional level to helping individuals and families retire is guided by a desire to see first-hand the impact he is making in the lives of clients at Oak Harvest.