The weak jobs report was ignored by the stock market on Friday. The S&P 500 was up 0.37% and the Nasdaq was up 0.94% bringing both to a new record high. The small correction at the end of May was a great buying opportunity as the S&P 500 is up 3.5% since then. This ‘buy the dip’ phenomenon has been a dramatic change in how the market has historically worked. Usually buying the dip after a 10% or 20% correction has been smart. Because investors have latched onto that concept, they have taken it to the next level. The logic is if a 10% correction should be bought, then a 5% correction should be bought. If a 5% correction should be bought, then a 2% correction should be bought. Under this premise, the stock market will rarely fall 10% because of the dip buyers. The last correction of that magnitude was late 2015/early 2016. The fact that it is becoming common knowledge that dip buying has worked historically is causing the market to become exceedingly expensive. Eventually valuations will hurt these dip buyers.

For now, things look very rosy. As you can see from the chart below, the VIX’s 9.75 close was the 4th lowest in history. The chart shows how the S&P 500 performs after closing below 10. Many of the below 10 closes have been recent, so much of the data is to be determined. As you can see, 6 out of 9 times the VIX closed below 10 the S&P 500 was down in the next year. The stats are about to be altered by how the market does in the next year because 6 days of closes below 10 are affected by it.

While the stock market has decided to ignore the hawkish Fed and economic data, the bond market is waving a yellow flag that there is likely going to be a recession in the next 2 years. The difference between the 10-year bond yield and the 2-year bond yield is usually negative before recessions. Bad economic reports combined with the Fed hiking rates flattens the yield curve. As you can see from the chart below, the yield spread has fallen below 0.90. The latest calculation I have made is the difference is 0.8712%. The yield spread is getting close to the lows seen in the middle of 2016. I expect the stock market to be 10% off its highs if the yield spread hits a new low for the cycle. That would mean the spread would have to go below 0.75%. The stock market cannot ignore what the bond market is screaming. The assumption that a recession could be coming in 2 years is based off the expectation that it will take over 6 months for the yield curve to invert. If it happens faster, we might see a recession in 18 months.

While Q2 GDP growth will likely be above the 1.2% growth rate seen in Q1, the expectations were hit by the weak BLS report. The NY Fed’s Nowcast updated its Q2 projection this Friday, but left it unchanged at 2.2%. The GDP Now forecast was lowered from 4.0% to 3.4% because of the BLS report. GDP Now lowered its real consumer spending growth expectation from 3.6% to 3.1%. I expect the weak BLS report to lower the blue-chip consensus to below 3%. It will be fair to start taking the GDP Now and NY Fed forecasts seriously at the end of June. A string of a few bad reports can still knock them down below 2%.

Not only is the treasury market disagreeing with the stock market, but the junk bond market is also in a rare disagreement with the stock market. As you can see in the chart below, junk bonds and stocks are highly correlated as both act as risk on trades. Either the junk bond market will rally further or the stock market will correct in the next 6 months. Investors need to keep an eye out for how the junk bond market is doing. It signals when the credit cycle is ending.

The credit cycle is how I determine when the next recession is coming. The only ways for firms to continue their buybacks to push their shares higher are with debt or cash flow. The chart below shows the reason buybacks have declined in 2016. Debt growth has been crashing after reaching a record high in 2015. Cash flow growth was barely positive in 2016. If credit growth falls to negative in 2017, cash flow growth won’t be able to make up for the difference and the stock market will likely fall into a bear market. Credit growth needs to stay positive to keep the party going. The last time it slowed to this rate was the mid-cycle slowdown in 2013. Since the recovery is long in the tooth, I don’t expect a third wind of debt growth.

Conclusion

The VIX is low, but the bond market isn’t as glib as the stock market. The yield curve is flattening. It will soon get to a point where it is signaling a recession if it continues at its recent rate. The GDP Now forecast is showing 3.4% growth in Q2, but I trust the bond market much more than that forecast. Just like the economy is appearing to rebound in Q2 from a weak Q1, it can fall back lower in Q3. Even though the small caps have shown margin weakness and record debt, the Russell 2000 has been rallying recently. The way this rally has worked, whenever you can point to a weakness in it whether its breadth or the transports, there’s a snapback effect, making it look perfect. If that snap back effect continues, junk bonds will rally in the next few weeks. I’m very bearish on junk in the intermediate term (24 months), but anything can happen in the next few weeks. Finally, I showed a chart which had the debt growth of S&P 1500 firms decelerating. That’s a signal the credit cycle almost over.