While the stock market’s decline isn’t extreme by any means, other related markets seem to show heightened fear. The correlation between stocks, bonds, and gold has been strong recently. Risk-on days see stocks & yields go up, while gold falls. Risk-off days see stocks & yields go down, while gold rallies. Today’s headlines:

1. Double volatility spikes
2. Stocks & bonds: part 1
3. 30-year bond yield sinking to a new low
4. Both yield curves
5. Stocks & bonds: part 2

 

Double volatility spikes

Here’s how a correction usually plays out:

1. The first wave in which the S&P goes down, VIX explodes and makes a high.
2. But as the S&P keeps going down, VIX’s spikes make lower highs.

VIX spiked more than 15% today, just 5 days after last Monday’s spike. However, VIX’s spike set a lower high.

 

When this happened in the past, VIX usually fell over the next month.

 

However, this isn’t consistently bullish for the S&P in the short term. As I said last weekend, stock market corrections usually see more than 1 DOWN wave, even if VIX doesn’t make a higher high.

 

Stocks & bonds

The stock market’s recent decline is not extreme. However, a lot of the extremes have occurred in safe-haven markets. For example:

1. Gold’s sentiment is high, yet it continues to rally.
2. Treasury bond sentiment is extremely high, yet Treasury bonds continue to rally (yields continue to fall).

This usually happens when a very strong “theme” emerges. This theme can swamp contrarian indicators in the short-medium term. (The obvious current theme is “trade war”). Bloomberg captured this theme and the accompanying contrarians with:

 

Stocks have been trending upwards over the past few months while yields have completely collapsed. As a result, the S&P:10 year Treasury yield ratio has soared.

 

This kind of surge almost always saw a bounce in Treasury yields over the next week…

 

…and was bullish for stocks.

 

 

We’ll look at bonds from multiple angles in this post. The overall message is clear: when bond yields do rally, it will not be a bearish factor for stocks.

30-year yields

The 30 year Treasury yield has sunk to a 3 year low.

 

When this happened in the past, the 30-year yield would often bounce in the short term. But what happened after that was a 50/50 bet. Once a trend gets going, it’s hard to know exactly when it will stop.

 

And once again, this isn’t bearish for stocks after 1 month.

 

Both yield curves

With bond yields falling, the 10 year – 2-year yield curve has come close to being inverted. This is interesting because:

1. This time, the 10 year – 3-month yield curve inverted months BEFORE the 10 year – 2-year yield curve
2. In the past, the 10 year – 3-month yield curve always inverted AFTER the 10 year – 2-year yield curve

So while the 10 year – 2-year yield curve was more widely watched in the past, the 10 year – 3-month yield curve was more accurate. But instead of picking 1 yield curve over another, we can just look at both of them.

 

Here’s what happened next to the S&P when both yield curves were below 0.1%

 

 

 

Overall, the yield curve is a sign that long term risk:reward doesn’t favor bulls.

Stocks & bonds: part 2

From a multi-month perspective, it looks like the S&P and bond yields are moving in opposite directions.

 

 

But on a day-to-day basis, almost all of the S&P’s gains have occurred on days when Treasury yield went up, and almost all of the S&P’s loses have occurred on days when Treasury yields went down.

Stocks and yields have a very strong day-to-day correlation.

1. It’s just that on days when stocks go up, bond yields go up a little. But on days when stocks go down yields crash. Hence on a multi-month basis, stocks and yields move in opposite directions.

Here’s this day-to-day correlation over the past 200 days.

 

 

There are only 4 other periods in which the S&P went up more than 37% over the past 200 days when the 10-year yield went up, and fell when the 10-year yield went down.

 

 

 

Sample size is small, and not consistently bullish or bearish. But overall, this tends to happen around periods of major uncertainty in the financial markets:

1. 2014: ex-U.S. currencies collapse, emerging market problems, commodity prices collapse
2. 2007: clear housing market problems, stock market top
3. 2002: after a big 2 year bear market and a recession
4. 1998: after a -20% stock market crash

A sign of the times.

Conclusion

Here is our discretionary market outlook:

1. Long term: risk:reward is not bullish. In a most optimistic scenario, the bull market probably has 1 year left.
2. Medium term (next 6-9 months): most market studies lean bullish.
3. Short term (next 1-3 months) market studies are mixed.
4. We focus on the medium-long term.

Goldman Sachs’ Bull/Bear Indicator demonstrates that risk:reward favors long term bears.