Over the last few weeks, we have been relatively neutral to slightly bearish on the market as the S&P 500 remained channel-bound. However, evidence is mounting that support is “cracking” and a correction is looming.
We recommend waiting for confirmation before jumping to conclusions, but there are a few key indicators that could trigger a shift to the downside in the near term.
The Federal Reserve
The Federal Reserve’s FOMC statement left interest rates alone, but it made a few soft comments about rising inflation and economic growth that indicate a rate hike in December is likely. We don’t think the statement has much substance, but it is interesting that the Fed perceives inflation to be on track toward its target. Rising inflation could force the yield curve higher (and bonds lower), regardless of the Fed’s actions.
It is a bit of a mystery why the Fed went forward with its meeting this month. It sent strong signals that any interest rate moves would be seen as “political,” so a change was extremely unlikely. For that matter, even strong language or guidance would have been perceived as political, which it wants to avoid as much as possible.
However, it did issue a statement, and it’s likely to have an impact on market prices. Unfortunately, Fed statements haven’t had a reliably positive influence on the market for a while.
As you can see in the chart below of the S&P 500 SPDR ETF (NYSEARCA:SPY), each Fed meeting over the past five quarters has a red flag placed next to it. The arrows show that, with one exception, the near-term reaction has been flat or negative.
It seems that investors are more interested in selling the news than taking on more risk following statements from the Fed. If we can infer anything about the future from the past, then the Fed meeting itself isn’t likely to strengthen support. While there aren’t many examples of real panic yet, there are a few other bearish signals emerging as well.
The high-yield bond market has been selling off again. While the losses aren’t severe, yet, they could get there very quickly. The problem is the relationship between bond performance and oil. As oil has been dropping, many energy company bonds are also declining in credit quality.
Oil company bonds represent an outsized percentage of the high-yield market, which is a significant risk to banks, funds and pension plans while so many of them are bordering on default. We recommend watching for a break of support on the iShares High Yield-Bond ETF (NYSEARCA:HYG) as an early warning that larger losses are looming.
While small caps aren’t diverging from large-cap stocks, the decline has been much more robust than within the S&P 500, which is usually a bad sign. This has been driven by the overweight exposure to biotech and oil stocks within the category, and it tells us something about risk appetite.
As prices drop into the “Brexit” range, the Russell 2000 could provide an early warning of a much larger correction. If the index heads further toward the post-Brexit lows, we would expect the decline in large-caps to accelerate as well.
While some bearish signals are emerging, we recommend maintaining moderate expectations for a market decline, rather than a crash. The VIX fear index is high, but longer-term volatility expectations remain very low.
Investors aren’t fleeing to safe-haven assets like the dollar, and although gold is rising, it is likely just a reaction to lowered interest-rate expectations. Until these indicators confirm the decline in stocks, we wouldn’t like anyone to get too worried.
To be clear, there is a big difference between a correction, which happens two to three times per year on average, and a bear market. We think there are several signs pointing to the former in November. However, a true bear market is still unlikely. We recommend taking advantage of the short-term downside, but support bounces could be extremely profitable once reached.
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