U.S. stock have been touching fresh yearly highs, but a recessionary bear market is still likely to hit, according to Tyler Richey, co-editor at Sevens Report Research.
The Dow Jones Industrial Average DJIA, +0.28% and S&P 500 index SPX, +0.15% on Monday closed at fresh 2023 highs, while ending less than 4.5% off their record levels, according to Dow Jones market data.
“We continue to respect the rally and acknowledge the trend in equities is still higher, but we remain ‘patient bears’ with regard to stocks given the deeply inverted yield curve,” Richey wrote in a Monday report.
“We view the fact that most Treasury spreads have inverted to levels not seen since the early 1980s as a clear warning sign that the more than 500 basis points of Fed rate hikes in less than 18 months was way too much for the economy to weather,” noted Richey.
There are five signs that could help investors identify the onset of a recessionary bear market for stocks, Richey said.
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A bull steeper of the yield curve: Investors should watch for a sharp bull-steepening dynamic in the yield curve, especially if the spread between the 10-year TMUBMUSD10Y, 3.969% and 2-year Treasury TMUBMUSD02Y, 4.882% moves above -83 basis points, as it would be the first step toward a further steepening dynamic, said Richey. The 2-year Treasury yield was at 4.85% on Monday, while the 10-year was closer to 3.96%, according to FactSet.
A bull steepener refers to a shift in the yield curve caused by short-term interest rates falling faster than long-term rates, due to the expected Federal Reserve rate cuts to prop up a faltering economy.
A considerable widening of high yield spreads: It should be viewed as a warning sign if the ICE BofA U.S. High Yield Spread rises more than 100 basis points from its current levels toward 5%, noted Richey. The spread stood nearly 3.8% above the risk-free Treasury rate as of July 28, according to Federal Reserve Economic Data.
A meaningful rise in the VIX confirmed by a spike in the Put/Call Ratio in the derivatives market. A significant increase in the Cboe Volatility Index VIX, +2.25%, a measure of the level of implied volatility of a range of options based on the S&P 500 SPX, +0.15%, would indicate a rising options demand. Meanwhile, a sudden rise in the put/call ratio would show that the demand is for puts suggesting downside protection, instead of calls. Put options give investors the right to sell a stock, while call options grant them the right to buy a stock.
Backwardation in the term structure of the VIX: If front month VIX futures rise above back month futures prices, it might be showing that sophisticated investors are increasing their hedging demand, Richey noted.
A sharp rise in the dollar index. “The timing of this one is a little trickier as a safe-haven bid in the dollar can develop after equities peak, but a firming dollar would offer clear confirmation of riskoff money flows gripping global markets,” Richey wrote. Investors should watch for a break above dollar’s DXY, +0.10% late-May high of 104.2, against a basket of rival currencies, which could indicate further upside for the greenback, noted Richey.