Last week, we saw stock market recovery which is always welcome event.
I believe for short term the stock market most likely has bottomed but true bottom is always retrospective. For true trend reversal we need at least three higher highs and three higher lows.
Source: The perfect speculator, Koteshwore
Macro economic picture has worsened in my opinion.
Chair Powell was as hawkish as he could be! Even Mr. Kaskhari came out this weekend via medium article (click here) stating that he was wrong on inflation expectations and is advocating for tighter monetary policy and the Fed’s balance sheet reduction. The Federal Reserve will reduce its balance sheet by selling bonds which will mop up excess money circulating in the economy.
If we look at the leading sectors in stock market right now are mostly inflation hedges: like commodities, oils materials which typical tend to do well when economy is at the peak and inflation is high.
The leading sectors in last 2 months are health care, Energy, materials, utilities and industrials as seen below:
The stock market is forecasting difficult time for economy and these are the sectors that tend to do well before recession is anticipated. Consumer defense, real estate and health care will do well during recessionary periods as well.
The materials, commodities and energy are raw material for stronger economy. It appears that the US economy is at around its peak. The commodities top and then go bust due to supply and demand dynamics. Higher demand causes higher prices, higher prices causes higher production which cause collapse in prices, hence boom and bust of commodity cycle goes.
Another important leading indicator in my opinion is yield curve. The short end of yield curve is controlled by the Federal Reserve and long end of the curve is usually controlled by the investors.
Recent yield curve is shown below:
The spread between 2 yr and 10 yr is narrowing, 7 yr and 10 yr is inverted. With 6 more rates hike this year, it is very conceivable that spread between 2 yr and 10 yr will invert in short order. The inversion in yield curve itself shouldn’t cause recession but it is window to bond investors’ expectations. They are anticipating difficult economic times ahead and rushing to buy longer term US treasury bonds to lock in the higher rates and selling short term bonds as they expect the economy will slow down and there will be timid growth. They expect that the Federal reserve will have to lower the rates in future when recession hits. Bond investors are usually right about the state of economy.
Yield curve flattening or inversion is not followed by recession immediately. It usually take around 18 months for the official recession to occur. As we all know that the stock market and bond markets are discounting mechanism and they are forward looking. They look well in advance. This also explains why growth stocks are doing poorly because majority of investors don’t see growth ahead.
What should we do?
The best thing to do in my opinion is to follow what stock market and bond market are forecasting. It appears to me that energy, commodities, materials and health care sectors will lead next leg up until recession hits.
Nice write up! It’s a tough market to navigate.
I feel like I am late to the party with energy, commodities, and materials. However, I like the healthcare sector.
I am short treasuries, via $TBT and $TBF shares and calls. Housing with higher interest and inflated prices, IMO, will come under pressure soon. I am looking for a way to short housing too.