The Market Flashing Red Now

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  • A new voice coming to Profit Watch
  • The major undercurrent in the market right now
  • Plus, why you need to know what type of investor you are…

It’s incredible the difference four months can make in the market.

Let’s go back to the start of December 2018.

The Federal Reserve was forecasting another three rate hikes in 2019…and the ongoing decrease of its balance sheet. This is the huge portfolio of assets it built up in the wake of the global financial crisis.

The Fed had an optimistic outlook for US and global growth.

Then came the Fed’s latest meeting last week.

Jerome Powell, the US equivalent of our RBA boss, cancelled all of that.

He said there likely won’t be any rate hikes this year. Oh, and the balance sheet? Ah, what is US$3.5 trillion among friends? We’ll keep it!

This has big implications for you as a trader or investor.

The conventional view right now is that the current Fed stance (‘dovish’, to use the lingo) is bullish for the stock market.

A friend of mine is saying, ‘Not so fast.’ His name is Peter Bakker and he’s an algorithmic trader.

You’re going to be hearing from Peter much more in Profit Watch in the near future. I’m thrilled we’re putting things in motion to make that happen.  

Peter has over 20 years’ experience in the market.

Right now, he sees undercurrents that unmistakably signal something is on the horizon.

He’s not saying the markets are going to tank tomorrow. Nor that they are going to blast off to unseen highs. Those kinds of predictions aren’t usually helpful.  

He’s an algorithmic trader.

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He looks at probabilities. Based on those, currently, he doesn’t like the risk to potential reward of the market.

Let’s go over why he’s concerned…

The current disconnect between bonds and stocks

One of the things that worries Peter is the yield curve and the behaviour of the interest rates.

Specifically, the 10-year Treasury note in the US. This sets the benchmark interest rate across the globe.

The American bond market, by the way, is way bigger than the equity market.

US$700 billion of bonds will change hands daily while only US$300 billion of stocks are traded.

And bond traders are presumed — quite correctly most of the time — to be the best judges of risk.

Let’s listen to what they’re hinting at right now.

The interest rate of the 10-year Treasury note will, in general, correlate positively with the market. That means it will rise alongside the market.

We need to pay attention when that doesn’t happen. You can see the two markets heading in different directions (divergence) right now in the chart below…  

A close up of a map  Description automatically generated

Source: Optuma

Apologies if they look like squiggles. The green line is US stocks (the S&P 500) and the black line is the yield on the 10-year Treasury note falling. You can see a big gap has formed.

Here’s why we’re focusing on this. Usually we get one of two outcomes when this happens:

  • Either the bond market corrects (bonds go down, yields go up) or,
  • The stock market does gown (or sideways, at least).

This same kind of divergence happened back in 2016. You might remember that was a tumultuous time in the world. There was the US presidential election, the Brexit vote, worries over China — and Prince died!

The bond market priced those events as risky. Trump’s election victory changed that assessment and bonds sold off, driving the yield up.   

Now we are in a similar situation: The US stock market sold off in late 2018 but has recovered.

But the bond market is flashing red. Consider why: The global slowdown, Brexit shenanigans, a possible European recession, and the ongoing and uncertain Sino-US trade war.  

Here’s what it boils down to for you and I…

Prepare for volatility

Peter tells me that the probability of an aggressive move in the stock market or bond market is extremely high right now.

Either the stock market will correct down in the next few months or the yield of the 10-year bond will pull up.

The latter is unlikely with the current stance of the US Fed.

That leaves us with an ‘above normal’ risk of a correction.

Now, you do need to know what type of investor or trader you are to take advantage of this idea.

Peter is a trader, not a stock picker. He doesn’t look to own businesses for the long term in the style of Warren Buffett.

He tries to surf momentum and volatility by trading the indexes. That’s not my style usually.

The direction of the market matters less for the small caps I focus on.

But here’s an idea to use the above scenario to your favour…

If you’re a trader, you might like to consider ways to play the short side of the market.

If you’re a long-term investor, you might find the next few months give you a more strategic entry point for businesses you’d like to own long term.

Cheers,

Callum Newman Signature

Callum Newman,
Editor, Profit Watch

How to find 2019's biggest stock market winners

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