August 20, 2019

Carol works downstairs. In last Wednesday’s big down day, she asked: “What’s up with this crazy market I see on the news? My nephew is good at trading stocks. He even said its nuts!” I said: “Everyone’s freaked-out about inverted yield-curves; it’s supposed to be a flag for recession. But the news needs to make money. They want your eyeballs. The quickest formula for that is creating fear.”

“I guess so,” she responded, “but stocks are moving so much!”

“Carol, here’s a question: Did you sell stocks this week?”


“How about your nephew?”

“No, I don’t think so…”

“I didn’t sell anything! I bet if we ask everyone we know if they sold, their answer would also be no.”

“Then who is selling?” she asked.

“AHA! It’s the machines.”

According to an article in Seeking Alpha published earlier this year, 80% of the market’s volume is based on algorithmic (algo) or computerized trading, which thrives in low-liquidity markets.

Source: “Algo Trading Dominates 80% of Stock Market,” January 1, 2019.

On Wall Street, many are lounging in their summer-vacation homes. Desks are staffed by junior traders. With fewer actual people on Wall Street, computers push prices around to capture intraday volatility.

As selling spiked last Monday, a $2 billion fund trader asked me why. I’ll summarize my answer:

  1. Our buy ratio fell, indicating that buying dried up. Whenever we see the buy/sell ratio fall below 45%, we’ve always seen more selling. Another selling week could see it drop below 45%.
  2. Only 22% of signals were buying, down from 35% the week prior. Buying hasn’t returned. ETF volumes rose – buying risk-off, selling risk-on. ETF volume typically spikes at the bottoms.
  3. Volumes were high on Monday but lower through the week. I think that selling isn’t over. Buying was defensive – concentrated in Reits, Utilities, and Health Care.
  4. This week was not the capitulation low. Normally, that’s when 50% of our universe shows sell signals. Think: the end of December 2018 – a definitive bottom.
  5. Looking at sectors, Energy, Financials, Materials, Industrials, & Discretionary felt the worst pain. Only Energy is close to oversold. That means we’ve seen worse selling before

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Bottom line: I expect to see more downside, but long-term investors should prepare for buying opportunities now. Near-term patience rewards investors.

We’ve warned of this August volatility for the past several weeks. All through July, we wrote about it, and right on cue, August 1 delivered heavy volatility. When liquidity dries up, algorithms need bad news to act on. Wednesday the news hit that the yield-curve inverted. Doom and gloom freaks everyone out (and sells more ads). Then algo-traders take advantage and push prices around. High-frequency, short-term, and day trading … all cause volatility. Bespoke Research says August is one of the worst months for performance and volatility. I have bad news for you: September sucks too, so be prepared:

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Don’t Freak Out About the “Inverted Yield Curve”

In the meantime, don’t freak about the inverted yield-curve.

Headlines paint the end of the world and a red flag for recession. But is it?

Not really. Things in the U.S. are looking great. Second-quarter earnings just wrapped up with fantastic numbers. About 75% beat earnings and 57% beat sales estimates. Profit margins are increasing.

Overseas, Germany slipped into a recession, and there is global growth slowdown as China’s admitting a slowdown. Latin America is a mess, evidenced by Argentina’s Miraval Index one-day -48% plummet last week, so global investors realize that U.S. stocks are an oasis. There’s a capital flight out of European stocks. They’re nervous about everything: Brexit, global slowdown, the U.S. wanting to buy Greenland!

Investors are fleeing to long-dated bonds because they’re safer, which squishes yields. If you lend for a long time, you get a premium. If you lend a short time, you get less. That’s a normal yield-curve (yellow below). But when everybody rushes to buy 30-year bonds, that yield-curve squishes down, and the front end might invert a little bit, delivering a red (last month), blue (last week), or green (now) yield curve.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

One headline screamed: “First yield-curve inversion since 2005, which preceded 2007-2009 recession: Inversions preceded every recession.” But, that’s just another way to lie with statistics… A more accurate way to phrase that correlation would be this: While every recession was preceded with a yield-curve inversion, not every yield-curve inversion has preceded a recession.

And frankly, this time, it IS different.

2007 was a leveraged debt bomb with speculative home buying assuming never-falling prices. Big banks bundled those mortgages together and sold them as AAA-rated paper to pension funds and endowments.

What happened? Defaults soared above expectations, and the housing market collapsed. The whole thing went up in flames. But today, we don’t have major levered debt bombs that anybody’s talking about.

But people still worry, so much so that most of Europe’s yield is negative, meaning investors prefer to pay for safe money than earn a risky return.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Again, U.S. earnings are great, corporate tax rates are low, and profit margins are high. While there are clear international risks, once logic prevails, there will be a rush into U.S. equities: specifically, there will likely be a focus on domestic small-cap names with low international exposure.

As you know, Trump delayed tariffs until December, but that rally fizzled after one day, met with negative yield-curve news. But facts remain, Bond interest is taxed as ordinary income while dividends are taxed as long-term capital gains. For high-income investors, holding stocks delivers 62% more profit!

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

This is very bullish, not bearish. Even if a recession comes, market peaks historically wait for 18–24 months after that event. And how does the market typically do after a yield-curve inversion? These are the average returns for the S&P 500 post yield-curve inversions since 1978.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Now is a good time to look for the best stocks with the strongest fundamentals, including those with strong 1-3-year growth rates, high profits, low debt, and unique business models.

These tend to be the big winners, so don’t freak. Relax and take a vacation – like Wall Street is doing.

This is August. But don’t forget September. Or October. Mark Twain once said: “October: This is one of the peculiarly dangerous months to speculate in stocks in. The others are July, January, September, April, November, May, March, June, December, August and February.”

About The Author

Jason Bodner

Jason Bodner writes Sector Spotlight in the weekly Marketmail publication and has authored several white papers for the company. He is also Co-Founder of Macro Analytics for Professionals which produces proprietary equity accumulation/distribution research for its clients. Previously, Mr. Bodner served as Director of European Equity Derivatives for Cantor Fitzgerald Europe in London, then moved to the role of Head of Equity Derivatives North America for the same company in New York. He also served as S.V.P. Equity Derivatives for Jefferies, LLC. He received a B.S. in business administration in 1996, with honors, from Skidmore College as a member of the Periclean Honors Society. All content of “Sector Spotlight” represents the opinion of Jason Bodner


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