The market has now exited its short-term trading range and the Ivory Hill RiskSIGNAL is still red, and we are sitting on 60% cash and we have increased our exposure to long-term Treasuries to roughly 12%. Although there are some excellent buys available, caution is still advised given the abundance of unfavorable data regarding the current economy and inflation that keeps emerging. It does seem like the markets are attempting to form a bottom, which is encouraging for the last half of the year. Even the bond market appears to be finding support and emerging from a temporary reversal trend, which could be telling us a different story.
On Wednesday, Powell & Company raised the benchmark federal funds rate by 0.75%, bringing the Fed Funds rate to a range between 2.25% and 2.5%.
Real gross domestic product (GDP) dropped at an annual rate of 0.9% in Q2. And when I was getting my economics degree, the textbook definition of a recession was two straight quarters of negative GDP, and the US has officially met that.
The government redefined what the definition of a recession is. Government officials, most notably Janet Yellen, were ahead of this announcement by hedging their definitions of recession.
On a side note, this reminds me of my time in the Army when we would be tasked to complete a Tank gunnery range at Camp Ripley, MN (in the middle of February and of course during a blizzard). We were often given three days to complete this task when the Army standard is given in weeks. When the clock was ticking down and it was obvious we were not going to meet our objective, the higher leadership would "modify" the standard (lower the bar) and then magically we completed the mission.
This means that two consecutive declines in GDP does not constitute a recession. Only the National Bureau of Economic Research (NBER) can declare a recession, and they look at various demand metrics and employment indicators, among other things, to make that call.
The Federal Reserve and White House are denying that we’re currently in a recession. Despite two consecutive quarters of declining GDP growth, National Economic Council Director Brian Deese said Thursday, "virtually nothing signals this period in the second quarter is recessionary."
Something is very wrong about that statement.
Deese doesn't have a great track record in my view. I am not keeping score or anything but here is a quote from a Washington post article published, May 5, 2021:
Translation: The same people who are currently denying the common definition of a recession are the same people who told us inflation was "transitory" over a year ago. Inflation is currently at 40-year highs.
The economy will continue to slow into the second half of 2022. Why? consumption growth simply cannot persist in a situation where:
Lower income consumers are getting squeezed by inflation that is sky-high. Food, Energy and Shelter make up more than 60% of consumer spending for the bottom 40% of incomes. That’s 10% higher than it is for the nation’s top 5% of income earners.
Meanwhile, collapsing asset prices are hurting the ultra rich. The top 10% of Americans by wealth own 88% of equity market assets.
On that point, the latest GDP report actually includes a 2.5% positive wealth effect and the number was still negative. This tells us that the party is most likely just getting started.
There is no greater contrast between what we observe and how officials perceive the US economy.
On the other hand, backward-looking policymakers focus on lagging indicators like job growth and the absolute values of consumer balance sheets.
Here’s a quick illustration of the stress currently on American households:
Inflation is at forty year highs
Real average hourly earnings are declining
Consumers are plugging the gap in consumption by using credit cards (consumer credit just hit all-time highs)
I posted on LinkedIn a couple months ago that Walmart's earnings release was most likely an early indicator that inflation was starting to control the consumer and that it should spill over into the rest of the retail sector. Q2 earnings results pretty much confirmed my statement. Walmart and Target have indicated that they are having inventory issues, and things seem to be only getting worse.
Consumer behavior is worsening every day; there is no doubt about that. Any attempt to argue that rising credit card usage is evidence of a resilient consumer base is wrong. Consumers are spending more on their credit cards because the souring costs of inflation are forcing them to buy groceries on their credit cards. The surge in discretionary stock prices we've seen in recent weeks was merely a weak rally.
This past week, I also paid attention to new home sales. The 590,000 figure for June was significantly lower than anticipated and almost matched the pandemic low from April 2020. In contrast, almost 850,000 new homes were sold in December 2021. There is no denying the deterioration of the US housing market. We have the highest 30-year mortgage rates since the 2008 global financial crisis, at about 6%. This has a significant impact on home affordability and buyer sentiment. The median sales price of homes has also started to decline. I believe it is safe to say at this point that the housing market has peaked, and the downward trend appears set to pick up speed.
The Bond Market is Calling For a Recession
Currently, stocks are receiving the majority of the market's attention, but Treasuries are also doing well. Treasury yield spreads are rapidly declining as the 10Y/2Y ratio falls to 20-year lows. Even while stocks are rising, the bond market believes that a recession is much more likely than not, as evidenced by the curve's severe flattening (and inversion in a few places).
Treasuries are now beginning to tell us the right story. More crucially, it appears that we are considerably closer now than we were even a few months ago to conventional risk-off behavior from government bonds. There is still some influence from Fed policy rumors, but it appears that bond market traders are once again concentrating on recession risk rather than trying to predict when the Fed Funds rate will peak. It appears that the top for long-term Treasury yields happened six weeks ago, barring a material change in conditions.
The 10-year/3-month yield spread, which some have said to be the true recession predictor, has fallen precipitously from 228 basis points in the first half of May to just 27 basis points right now. Whether you focus on the signals or the basic economic facts, the situation is rapidly getting worse.
Below is a chart of long-term Treasuries against intermediate-term Treasuries. As you can see, since December of last year, this ratio has been in a downtrend, meaning intermediate Treasuries are outperforming long-term Treasuries. This is usually a sign of low volatility in the stock market, but this ratio has been skewed because the bond market has been in a "black swan" for the last year or so.
BUT, recently, this chart has been trying to make an uptrend, which means that 20-year Treasuries are becoming more of a safe haven asset. An uptrend in this ratio means that market conditions are telling us that higher volatility is more likely than not.
Why this matters
We know that, in general, stocks and bonds tend to move in opposite directions. Of course, that hasn’t happened as much in 2022, but, historically, that’s usually the relationship. As economic conditions deteriorate, investors tend to move away from stocks and towards the relative safety of Treasuries. Measuring long bonds against intermediate bonds gives us a pulse on the overall buying in Treasuries and removes stock market price activity from the equation.
It’s important to examine the Treasury market independently of the stock market because it tends to more accurately reflect economic conditions and expectations. The stock market is more vulnerable to overextended trading activity (TSLA and ARKK), whereas the Treasury market tends to remain more grounded in reality. The bond market tends to be right about the state of the economy more often than the stock market. Therefore, this is an important ratio to watch.
In short, when long-term bonds outperform, it indicates investors are becoming more cautious and moving into safe havens. This would be an early indicator that higher volatility is more likely than not, and currently it looks like it is getting close to signaling another leg down is coming for stocks.
Those of you who are familiar with my view on markets know that I am obsessed with downside risk and that I love using early indicators of higher volatility as a weapon for offensive positioning.
Let's put this ratio to the test via a back test.
While this signal looks strictly at Treasury prices, the practical application of the strategy will involve investing in either the S&P 500 (SPY) or the iShares 20+ Year Treasury Bond ETF (TLT). When the signal is red, Treasuries are the play. When the signal is green, this will indicate that we should move into the S&P 500. I use long-term Treasuries because it provides an opportunity for your portfolio to produce positive returns even when stocks are falling.
Bottom line, in this example, we will always be invested in either SPY or TLT at all times.
As you can see, the rotation strategy significantly outperforms the S&P 500 over the long term. I highlighted the max drawdown column because by rotating between stocks and bonds, you are able to significantly outperform the market by avoiding most of the major market crashes.
Long-term outperformance is achieved through the avoidance of major market crashes.
Based on this analysis, if this signal flips red, there is a 60% chance that higher volatility is likely and we could see the market whipsaw back down to new lows.
When the Ivory Hill RiskSIGNAL is red, there is over a 70% chance that the market will continue to go down.
We are not in the guessing game, we are in the math and odds game.
We will continue to be patient, sit on our cash and bonds, and let the market tell us where the bottom is.
Feel free to reach out to me and use me as a sounding board.
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President