The US market has responded positively since the Fed communicated a shift in policy to a loosening bias. To this end, a rate cut of 25bps is likely come the 31st July. However, the below analysis suggests that a more cautious stance may be in order.
Yield Curve Inversion
Consider the following chart:
Past performance is not an indicator of future results.
Chart source: tradingview
We have an interesting causality here. The upper chart shows the yield curve as per the US 10 Yr. bond and US 3-month bill. At current levels it is inverted (below the green horizontal). i.e. the shorter-term bill offers a higher yield. Historically inversions have preceded many US recessions. In the above chart the inversions are represented by a red vertical. In the above, we have 3 inversions.
The second chart shows the federal funds rate. Following the first 2 red verticals there is a lag before the fed begins its rate cuts. These are represented by the orange verticals. However, the rate cuts tend to lead declines in the bottom chart, which is the S&P 500.
The drops in the S&P500 in the above data set are severe and include the tech-wreck in the early 2000s and then the devastating global financial crisis (GFC) leading into 2008. Thus, the cut scheduled for end of July in this context is worrisome if the chain of causality still holds.
The Underperformance of Transport
Consider the following chart:
Past performance is not an indicator of future results.
Chart source: tradingview
The upper chart shows the S&P 500. The blue rectangles show the periods of the tech-wreck and the GFC. The bottom chart is the relative strength between the Dow Jones Transport Average and the Dow Jones Industrial Average. Prior to both of the declines in the S&P 500 we see that the relative strength chart was falling (first two negatively sloped green trendlines). I.e. the transport sector was severely underperforming the industrial sector. Please note that this is the current case (third negatively sloping green trendline).
Small Cap Underperformance
Consider the following chart:
Past performance is not an indicator of future results.
Chart source: tradingview
The upper chart here is the same as in diagram 2. It shows the previous two bear markets (the tech-wreck and the GFC). The bottom chart is the relative strength between the Russell 2000 and the S&P 500. That is the relative strength between small cap stocks and large cap stocks. Please note that both bear markets were preceded by a period of underperformance in the small cap index i.e. Again, this is the current case (negatively sloping green trendline).
Conclusion
Given the chain of casualty in diagram 1 and that the transport and small cap stocks are in an underperforming phase as per diagrams 2 & 3, prudence suggests a cautious approach. Whilst it is clear that not all transport sector underperformance leads to a sell-off in the S&P 500, it seems to be a phenomenon prior to a bear market. Likewise, small cap underperformance does not necessarily lead to a bear market. However, again, the declines in the above data set have been preceded by this phenomenon. Thus, a number of variables are aligning which may suggest a bear market is near.