Mon 12/31/2018 8:31 PM
Chart Advisor | INVESTOPEDIA
Focus on the Price
By John Jagerson, CFA, CMT
Monday, December 31, 2018
1. Don't be too confident that bears will win in 2019
2. Yield curve could set up banks for big gains
3. The January barometer? Not so much.
Major Moves
I was chatting with a professional trader friend of mine last week and we got into a debate about how likely it is for the economy to go into recession in 2019, which would also likely mean that the S&P 500 would remain in a bear market. It was an interesting conversation and it made me think of three reasons why recessions and bear markets are so difficult to identify in advance.
1. By their nature, economic contractions and bear markets tend to be short-lived (or at least that has been true for the last 80 years in the US). The most recent decline is a good example of what I mean: the market fell 20% over 57 trading days, but in order to lose that 20% the market had to gain 25% over the previous 341 trading days. The market moves down much faster than it moves up, so investors get less warning from market technicals than we do for bullish rallies.
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2. The base rate for large corrections is very rare. That means that although investors are very fearful of downturns they don’t happen very often. For example, the last 20% decline in the S&P 500 was in 2011, and the time before that was 2008. In over 10-years there have only been three market declines of 20% or more. Further, there have only been two periods of economic contraction (2011-2012, and 2014-2015) since the financial crisis in 2008.
3. Finally, the most vexing problem with predicting bear markets is that, by definition, they start at the point of maximum optimism. A bear market begins from a high, which was just as true in 2018 as 2011 or 2007. The inverse is also true, bull markets begin at the point of maximum pessimism (the bottom of the decline).
Identifying that point of maximum pessimism—or what some investors refer to as “capitulation”—is usually easier than correctly identifying the highs because bottoms take longer to form and produce more reliable technical signals. However, what investors should prepare themselves for is a consolidation at the lows. Before the most recent declines, I thought we might’ve had a chance at completing a consolidation in October and November. Although November’s technical pattern failed to breakout, we should be looking for something similar in the first quarter 2019 to signal a recovery.
In the Investing for Beginners course, I show in detail how investors can profit from a bull and bear markets and how to protect their portfolio when prices start to fall. Use code HAPPY2019 at checkout for 30% off any of the courses in the Investopedia Academy. Get started on your 2019 education resolutions right away!
Read more:
What is a Bear Market?
What Causes an Economic Contraction?
Capitulation Can Trigger Gains
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Risk Indicators: Yield Curve
The yield curve (as measured by the difference between the 2-year Treasury bond yield and the 10-year Treasury bond yield) has been improving since it hit its low on December 5th, when the difference between those two interest rates was almost zero. This is an important indicator for several reasons, one of which is that when the difference between these two interest rates is very small, bank profits go down.
Banks make money when they are able to lend at a higher rate than they borrow. Basically, when the yield curve is flat, the difference in yields at which banks are lending and borrowing shrinks. As you can see in the following chart, I have compared the SPDR S&P Regional Banking ETF (KRE) with the difference between the 10-year and 2-year interest rate. When the spread is getting wider, banks will perform very well such as at the end of 2016. When the spread is narrowing gains are more difficult to achieve, volatility rises, and bank stocks are prone to big price shocks.
Even when adjusted for dividends, banking stocks are off 50% more than the S&P 500 for 2018. Most of those declines are due to the narrowing spread between interest rates. However, if the yield spread continues to improve, banking stocks could be some of the biggest winners in 2019. This is especially true if energy prices continue to rise. Regional banks in the Southeast and Midwest US (where the energy industry has the biggest impact on the economy,) could be in a position to benefit the most.
Read more:
Impact of an Inverted Yield Curve
Understanding Energy ETFs
What is the Yield Spread?
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Bottom line: Don't judge 2019 by January's performance
Traders start talking about the January barometer around this time of year. The idea is that if stocks post gains in January, the rest of the year has a high likelihood of ending positive. However, if you exclude January’s returns from the historical studies then we find that the January barometer has no predictive value. This is an important thing for investors to remember because the market has been so choppy over the last two or three months. True market tops and economic corrections are very hard to predict. If January turns out to be disappointing or flat, be careful about judging the rest of the year the same way. Earnings are expected to be another blowout quarter so a recovery in the first six months of 2019 is still a high probability.
Read more:
What is the January Effect?
Breaking Down the January Barometer
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