Market Analysis - SPY Performance

18 Jul 2022

In this post, I will attempt to analyze where the market currently stands, and present both a strong bull case and a strong bear case.

Bull case:

First, the chart:
The chart above shows the S&P 500 ETF (SPY) on a 4h timeframe. The yellow and orange lines are exponential moving averages that represent the MA Exp Ribbon. As noted in a prior post, the MA Exp Ribbon acts as resistance when price hits it from below. In order to pierce through the ribbon, and make a bullish breakout, a candle must do so on high volume and with strong momentum. On the bottom is the Stochastic RSI oscillator, which helps measure momentum. For the first time, in a long time, the 4h chart of SPY has seen price near the top of MA Exp Ribbon with strong momentum building to push through it. It is quite likely that the price will break through.

Second, the VIX:
As the chart below shows, the VIX has broken down from the trend that it held during its most volatile period over the second quarter. Just be cautious and patient because the VIX has not yet broken below its weekly MA Exp Ribbon.


Third, the Advance-Decline Line (ADL):
The advance-decline line has broken out and is absolutely soaring. This is possibly one of the most bullish-looking charts out there. The advance-decline line is a technical indicator that plots the difference between the number of advancing and declining stocks on a daily basis. The advance-decline line is used to show market sentiment, as it tells traders whether there are more stocks rising or falling. It is used to confirm price trends in major indexes, and can also warn of reversals when divergence occurs. Right now there is a strong bullish divergence and the major indices have yet to break out.


Seasonality:
The current period (mid- to late-July) is typically bullish from a seasonality perspective: charts.equityclock.com/sp-500-index-seasonal-chart . Indeed, there was a bull run during this period even in 2008 during the Great Recession.

Bear case:
(Warning this part is scary - but remember never to invest or trade based on emotion)

Yield curve inversion:
The 10-year minus the 2-year Treasury yield is used to detect an impending recession. When the 2-year yield rises above the 10-year yield that creates a yield curve inversion, which can often indicate that a recession is coming. In essence, it creates the presumption that shorter-term yields are higher than longer-term yields because we're in the late phase of an economic cycle when the economy is overheating, and that soon, the economy will slow down. Right now the yield curve inversion is very steep. In fact, just last week, the yield curve inversion actually steepened to a level that was even worse than what we saw before the Great Recession.



Perhaps even more alarming is the extremely odd fact that the 10-year minus the 3-month Treasury is NOT indicating a recession. The federal reserve uses the 10-year minus the 3-month as a more reliable indicator for detecting an impending recession than the 10-year minus the 2-year.

Right now that indicator is only showing a 6% chance of a recession in the year ahead: newyorkfed.org/research/capital_markets/ycfaq

However, there's a major problem that throws into question the reliability of that indicator at the current time, and that problem is: The Rate of Change in the 10-year yield is off the charts. Look at the 10-year yield Rate of Change on a 3-month basis:



There's no way the 3-month yield could possibly invert relative the 10-year yield when the latter's rate of change is off-the-charts, unless the former's rate of change was even more off-the-charts (as we see with the 2-year, which is why the 2-year was able to invert against the 10-year).

Here's the 2-year yield rate of change:


Therefore, the 10-year minus the 3-month may be showing no inversion, not because the chance of a recession is actually low, but more likely because the indicator itself is no longer working because the rate of change in the 10-year yield is so parabolic. The 10-year minus 3-month indicator only reliably works if the assumption that the 10-year yield rate of change will be relatively stable compared to the 3-month yield rate of change holds true. In the current environment, that assumption does not hold true.

We've never seen this kind of rate of change in the 10-year yield during the period for which this indicator has been used to predict recessions. The 3-month yield would have inverted against the 10-year yield months ago, if the 10-year yield had remained relatively stable as it has during the past several decades. However, the 3-month yield cannot invert against something moving so fast to the upside. This is just simple math. This is extremely worrisome because many people are using this tool as a reason to believe that no recession will occur, when in fact, the tool has likely broken.

In the scientific community, we know that a tool only works if its validity and reliability can be established. Validity refers to the extent to which the tool actually measures what it is being used to measure, and reliability refers to the extent to which the tool consistently makes accurate measurements. In this case, the reliability of the 10Y-3M tool has broken down because the assumption that the 10-year yield would always be more stable relative to the 3-month yield is not true this time around. This time is indeed different...

So I leave you with these strong bull and strong bear considerations, and it is for you to determine how you want to play the market. Remember the rules of good trading!

18 Jul 2022

Nota

To be clear, what I am arguing is that the 10-year yield minus the 3-month yield only works as a recession indicator if the assumption that the 10-year yield rate of change is less than the 3-month yield rate of change holds true (i.e. the long-term yield is less volatile than the short-term yield). Whereas if the 10 year yield rate of change is higher than the 3 month yield rate of change, the tool would never be able to trigger, and thus the tool is not valid as a measure of recession in the context of the assumption not being true. For the first time since the tool has been used to gauge whether a recession is coming, the 10-year yield rate of change is higher than the 3-month yield rate of change. Therefore, the tool is currently producing what scientists would call a "false negative" -- meaning that the tool is incorrectly indicating that no recession will occur.

18 Jul 2022

Nota

Anomalies like this, where assumptions are violated and indicators break down, usually occur because a Supercycle (or a trend that has been in place for decades) has ended. The time during which the indicator was developed and popularized creates the impression that its underlying assumptions will always hold true and that the indicator is valid and reliable. However, questions of validity and reliability of the indicator can occur when a major trend reversal occurs. Below we see that the decades-long trend of lower 10-year yields has been definitively broken, and now greater volatility (to the upside) in these yields is occurring. Only time will tell if this pivot ends up being the start of a new Supercycle, but generally, when resistance is broken, it becomes support. The most optimistic outcome is that the trend in 10-year yields will now shift to a sideway trend rather than the less favorable outcome of it converting to an uptrend.