Does Recent Stock Market Action Indicate a Recession?

I've been reading and hearing a lot about an impending recession, which reminds me of the saying that, when everyone thinks alike, everyone is usually wrong. That's not to say everyone is expecting a recession, but we may have reached a point where there is sufficient concern to suggest that a mild one may already be factored into prices.

Also, several observers have suggested that a recession is likely in the "next two years." I certainly do not rule out such a possibility, since that would imply a contraction 4-years from the 2020 recessionary experience, which is not inconsistent with historical precedent over the last 150-years.

Long-Term Momentum Suggests an Extended Correction or Bear Market is Likely

That said, the market typically looks ahead and peaks 6-to-9-months ahead of recessions. Consequently, if we assume that a contraction does lie 2 years down the road, then there could well be another year or more of bullish stock market action before the post-2020 bull move is over. We tend to think of the market either going up or down for an extended period. Quite often, though, its trajectory takes the form of a 1-to-2-year trading range. Think 2011-12 or 2015-16, for instance.

The arrows in Chart 1 approximate the long-term KSTpeaks for the inflation adjusted S&P Composite. History shows that such action is typically followed by a bear market. However, the chart shows that trading ranges have been more the norm since the late 1990s because economic recoveries were more extended during that period. The solid arrows identify the two bears, in 2000-2002 and 2007-2009, while the dashed ones reflect trading ranges, which were characterized by economic growth slowdowns. The 2022 arrow is in blue because it is unknown whether forthcoming action will turn out to be a full-blown bear or a trading range.

Credit Spreads Argue Against a Bear Market

Forthcoming economic slowdowns or actual contractions often show up in the form of deteriorating credit spreads, where risky high-yield junk bonds are compared to higher-quality, lower-yielding treasuries. One way of accomplishing this is to compare the iBoxx High Yield Corporate Bond to the iShares 20-year+ Treasury ETF (_HYG/_TLT). A rising ratio indicates superior performance by the higher-yielding corporate bonds and reflects growing confidence, because investors are optimistic about the economy. A declining relationship, on the other hand, tells us that bond investors are more concerned about the possibility of defaults due to weak economic conditions, so they pressure the HYG. Think of it as a kind of canary in a financial coal mine.

Chart 2 replicates the first chart, but narrows in on a more recent activity since 2007, since the HYG has been listed for as many years. Note that every time the KST for the inflation-adjusted S&P has peaked, the ratio has also fallen, thereby reflecting some concern about the economy. The latest KST sell signal has been accompanied by strength in the ratio, not weakness. Indeed, it has succeeded in breaking above its secular down trendline. It's possible the break will prove to be false, but, with the evidence as currently presented, it looks like a valid break.

Chart 3, featuring just the ratio, supports that idea, as all three KSTs are in a rising mode. The short-term series may be a little overextended and, therefore, suggestive of a near-term pull-back. However, its re-accelerating long-term counterpart argues for further ultimate gains. For those might be looking for a repeat of the 2007-2009 experience, it's as well to note that current  price action from this relationship is exactly the opposite to that which preceded the financial crisis.

If Rising Rates are a Problem, Why are Stocks Outperforming Bonds?

When interest rates rise, investors inevitably run for the exits. That's because they fear those rising rates will feed back to economic weakness. While this is eventually true, the initial phase of rising rates is caused by a growing economy, when improving profits outweigh rising interest rates. However, the arrows in Chart 4 show that stocks, in their own right, do not usually peak until after they have begun to underperform bonds. Currently, there is no indication of that happening, as the ratio has just cleared a resistance trendline. Moreover, its long-term KST has started to re-accelerate. Both factors suggest there is more to come on the upside, both for the ratio and the S&P Composite.

Voting for Value over Growth?

Whatever direction stocks in general may decide to take, it looks as though a major internal shift may be taking place. In this, I am referring to the ratio between the S&P Value to the S&P Growth ETFs. In that respect, Chart 5, tells us that this relationship has reached a critical chart point. The short-term KST is in a corrective mode, so a breakout could be delayed. That said, this indicator has begun to flatten and, with help from the intermediate KST, could mount a credible rally right away.

Even more encouraging for value investors is the fact that the long-term KST for the ratio in Chart 6 has begun to re-accelerate on the upside. The green arrows tell us that previous KST upside reversals have consistently been followed by a small rally in the ratio, but an even bigger one for the S&P itself.

Conclusion

The long-term KST for the inflation adjusted S&P Composite has gone bearish. Historically, this kind of action has been followed by a bear market or an internally corrective trading range. Price action for several intermarket relationships suggest that the latter alternative, embracing a one-year-plus trading range as the more likely of the two.

Good luck and good charting,

Martin J. Pring

The views expressed in this article are those of the author and do not necessarily reflect the position or opinion of Pring Turner Capital Groupof Walnut Creek or its affiliates.