It has been a very tough couple of days for traders, with the choppy action in United States stocks frustrating both the bulls and the bears. As for Wednesday, well, it was another tough session in the stock market today. The SPDR S&P 500 ETF (NYSEARCA:SPY) fell 2.96%, while the PowerShares QQQ ETF (NASDAQ:QQQ) dropped 2.99%.
The cause? The yield curve.
What’s the Yield Curve All About?
Before we do anything, let’s talk about this yield curve and spreads.
In a healthy environment, one can plot the yields of bonds on a chart and see a positive slope, basically meaning that as the duration of the bond gets longer, the yield goes higher. However, when you keep hearing about a flattening or inverting yield curve, it means that the opposite is occurring — that short-duration bonds are yielding more than long-duration bonds.
This development shows itself in the spread. Traders often look at the 10-year/2-year Treasury spread. As this spread — measured by the 10-year yield minus the 2-year yield — approaches zero, investors start to grow leery. When it inverts, meaning the 2-year yields more than the 10-year, then investors get a bit finicky.
That’s what happened on Wednesday and that’s what caused the selloff.
Recession Implications
Some of you might be wondering, “what’s all this hoopla about bond yields anyway?” Well, the hoopla comes from the fact that an inverted yield curve — and in particular, a negative 10-year/2-year spread — has historically preceded economic recessions with surprising reliability.
Don’t forget, when the algos see the negative spread on the 2-year/10-year or recession headlines start spreading, they start selling. That’s just the way it is. It doesn’t help that China’s economic numbers aren’t all that hot, while Europe’s strongest member — Germany — hovers just above contraction territory.
For argument’s sake, let’s assume that a U.S. recession is on the way, even though the U.S. still has a strong labor market and relatively healthy businesses. What does that mean for the stock market?
Stocks tend to be forward looking, while economic readings are lagging indicators. So we should surely expect the market to be in trouble before a recession is actually on the books. However, that doesn’t mean markets peak or decline directly after a 2-year/10-year inversion.
Of the last five recessions, the yield curve inverted an average of 17 months before the start of the recession. At its fastest, it was 10 months early. At its slowest, it was 24 months — two years full years.
Referring to the time between the inversion and the recession as the “lag period,” stocks performed well. The S&P 500 was positive four of the five times, recording gains of at least 11% on each of those four years. Three of those years boasted gains of more than 22%. The one year it didn’t was amid the dot-com bust, a bubble we certainly aren’t matching in U.S. equities at the moment.
So while the worry is real, investors need to remember that the U.S. economy is still doing relatively well and that just because we have a brief 2-year/10-year inversion (so far), doesn’t mean we’re headed for the gallows tomorrow.
Movers in the Stock Market Today
Macy’s (NYSE:M) did well to rally off the lows, but the 13.3% decline was still enough to send shares to new 52-week lows. The company badly missed on earnings, reporting a profit of 28 cents per share vs. expectations of 45 cents per share. In-line revenue and a cut to management’s full-year earnings outlook didn’t help matters.
Nordstrom (NYSE:JWN), Kohl’s (NYSE:KSS), J.C. Penney (NYSE:JCP) and others heavily sold off in sympathy. Keep in mind, Walmart (NYSE:WMT) will report on Thursday too. It has been a stalwart in the retail space.
Keeping with retail, Canada Goose (NYSE:GOOS) and The RealReal (NASDAQ:REAL) were hammered too. Canada Goose fell 7.5% even as revenue of $71.1 million scorched estimates of $41.1 million. Worsening profitability likely alarmed investors, despite the torrid revenue growth.
For REAL, a top- and bottom-line earnings beat led to an initial surge of almost 20% in after-hours trading. That flipped to a 15% decline for the stock, as the recent IPO makes new lows. Traders can wait for a reversal before diving into this one.
World Wrestling Entertainment (NYSE:WWE) was one of the few winners on the day. Shares climbed 1.1% after Rosenblatt analysts initiated the stock with a buy rating and $85 price target. Although, it’s worth pointing out that this name is down 16% in the last three months and 23% in the last six.
Bret Kenwell is the manager and author of Future Blue Chips and is on Twitter @BretKenwell. As of this writing, Bret Kenwell did not hold a position in any of the aforementioned securities.
