Investors are taught that bear markets can't occur unless the Treasury yield curve inverts - that is, unless short-term interest rates are higher than long-term interest rates.
And that can only happen if the Federal Reserve raises the Federal Funds rate, which is the short-term rate that the Fed controls.
But that measure may be off the mark this time, and here's why...
New Realities Have Changed the Predictors
In general, a steep yield curve indicates that the economy is growing and is far from recession, and a flattening yield curve suggests that growth is slowing.
But investors would be unwise to rely on this measure alone to convince themselves that the stock market couldn't possibly experience more than a run-of-the-mill correction, which usually means a 10% decline from its high.
But traditional market metrics have been distorted by five years of zero interest rates, three rounds of QE by the Federal Reserve, and additional QE initiatives in Japan, China, and Europe.
The signals being emitted by the yield curve may not be as reliable as they once were in our post-crisis world, a reality we need to acknowledge.
The bigger issue, of course, is how we manage to stay ahead of the data and avoid catastrophic portfolio losses that sap our hard-earned gains.
Here's how we will navigate through the shoals...
Mixed Signals Throughout the Market
Thus far in 2014, the yield curve has flattened significantly but remains very steep. Year to date, the 2/10 curve (the difference between yields on two-year and ten-year Treasuries) has narrowed from 261 basis points to 186 basis points. While 75 basis points is a lot of flattening, the curve remains steep and far from the levels that would indicate that the economy is anywhere near to entering a recession.
Other economic indicators also suggest that a recession is unlikely. The unemployment rate has dropped sharply and is now under 6%, having logged in at 5.9% in September. GDP growth, which faltered in the first quarter at least in part due to record cold weather, has rebounded and is likely to exceed 3.0% over the second half of the year.
Moreover, for three of the last four quarters, growth has clocked in at better than 3.5% before inflation and close to 5.0% after inflation. That is a long way from a recession.
Other market signals suggest that economic growth could slow down significantly before the yield curve sends its traditional signal that the economy is about to enter a recession.
Let's look at three economic measures and two industry sectors generally considered critical to any analysis of a market's directional change....
Inflation: Traditional inflation measures in Europe and the United States are flashing red. Markets are currently priced as though U.S. inflation will not reach 2% for the rest of the decade. In Europe the inflation picture is much more troubling, with deflation posing a serious and immediate risk.
Oil Prices: Oil prices have fallen off a cliff. Brent is now trading at close to $80/barrel, down 25% from its June 2014 high. This is due to slowing demand resulting from faltering economic growth around the world.
Outside of the United States, most of the rest of the world is either in a recession or about to enter one (with the exception of China, which is still growing but slowing). One would expect oil prices to be much higher in view of the geopolitical tensions in the Middle East, but prices have continued to drop even as the threat posed by ISIS has grown.
Oil is the key global commodity, and its plunge is a warning sign that the world may be on the cusp of a major slowdown from which the U.S. would not be immune.
Employment: While the unemployment rate has dropped below 6%, this is only because the labor participation rate has dropped to a nearly 40-year low. The United States has a structural unemployment problem that is leaving almost 100 million people out of the labor force, exacerbating wealth inequality and increasing poverty levels and dependency on government support programs.
Today, 6% unemployment is not the same as 6% unemployment was before the crisis when many more people were part of the workforce.
Transportation Stocks: Airline and trucking stocks have been decimated in recent weeks. Airlines have been hit, of course, by Ebola fears. Normally, lower oil prices should benefit these groups. The fact that they are selling off suggests that investors are expecting economic growth to drop off sharply. Ebola has the potential to freeze global travel and seriously impair global growth until it is brought under control.
Cyclicals: Other economically sensitive groups have sold off sharply including autos, housing, diversified industrials, machinery/agriculture/construction, and energy. These are among the sectors that have suffered the worst technical damage during the sell-off. If the stock market forecasts the economy, it is forecasting heavy weather.
Within the context of these mixed signals, it's no wonder investors remain skittish; committing fresh capital to the market feels risky, and it is quite reasonable to ask "what comes next?"...
Most signs point to the current sell-off being limited to a 10% correction.
But we are living in an unprecedented post-crisis world where markets have been distorted by five years of zero interest rates and successive bouts of quantitative easing. Accordingly, it is reasonable to ask whether traditional market signals will be as reliable as they have in the past.
A healthy stock market requires sustainable organic growth. U.S. stock markets have risen on the back of financial engineering, low interest rates, and other non-organic factors that are not only unsustainable, but disguise underlying weakness in capital spending and organic earnings growth.
The current sell-off, painful as it has been, was long overdue; the real question is whether it will morph into a sustained bear market that recognizes the economy is overleveraged and central bankers have not solved the problems that led to the financial crisis in the first place.
Right now I believe the S&P still has a significant amount of ground to give up, with a support level as low as 1,775 on the horizon. Meanwhile, yields for the 10-Year Note may touch 1.75%, a full 25 basis points lower than current conditions.
Of course, all bets are off the table as the Ebola crisis escalates, or any of the other geopolitical hotspots take a turn for the worse.
About the Author
Prominent money manager. Has built top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.