The Market Mosaic 11.20.22
Falling rates boost stocks, but only until investors discover the real signal.
Welcome back to The Market Mosaic, where I gauge the stock market’s next move by looking at macro, trends, market internals, and the mood of the crowd. I’ll also highlight one or two trade ideas using this information.
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Also, be sure to check out Mosaic Chart Alerts. It’s a midweek update covering my best chart setups among long and short ideas in the stock market, along with specific levels that would trigger a trade.
Now for this week’s issue…
When consumer and producer inflation reports for the month of October rose less than expected, hopes leaped for a Federal Reserve pivot to easier monetary policy. The stock market surged with optimism, with the S&P 500 gaining 6% since the Consumer Price Index (CPI) was released.
But interest rates are another key dynamic driving the upside in share prices. Rising 10-year Treasury yields have accompanied falling stock prices for much of this year. But after touching 4.24% a month ago, the 10-year has pulled back to 3.81% as you can see below.
That has helped fuel a rally in stocks, as rates can impact stocks through two main avenues. One is the competition for capital because as rates increase, it draws investor fund flows to bonds through more attractive returns along with less volatility relative to the stock market.
Another avenue is how corporate valuations are driven by expected future cash flows, and how those future profits are discounted to the present. A higher interest rate makes future cash flows worth less, and vice versa.
So the pullback in rates is helping stocks rebound. But while falling rates has stoked short-term optimism, there’s another reason for longer-term concern.
Reflecting the Growth Outlook
Although initially met with optimism, the harsh reality is that the pull back in interest rates is a reflection of the growth outlook for the economy. With the front end of the yield curve staying elevated due to tighter Fed policy, the pullback in longer-dated rates has made yield curves even more inverted. And yield curve inversion is historically a reliable recession signal.
I’ve written extensively about my preference for the 10-year/3-month yield spread, which is now as inverted as the period heading into the dot-com bust and 2008/2009 financial crisis. I posted this update last week:
But that’s just one yield curve of many. That’s why I follow how many yield curves are inverting as a recession indicator. Just take a look at the chart below from Crescat Capital that measures the percent of all yield curves that are inverting, which now stands at over 70%.
The troubling signs for the growth outlook is showing up in other metrics as well, like with leading economic indicators that continue to deteriorate. I wrote about the significance of the Conference Board’s Leading Economic Index here, while the decline into negative territory worsens as I highlighted in this post:
So while the recent drop in rates has helped boost stocks, I expect the underlying economic driver behind the recent decline in yields to present another obstacle to stock prices.
Now What…
Up to this point, the bear market in stocks has been driven by compression in valuation multiples (blue line). This chart from J.P. Morgan illustrates as much. But as I highlighted above, the next phase to pressure stock prices will have more to do with corporate earnings, which up to this point has held up (black line).
But that’s also why I focus on companies and sectors bucking the trend of emerging profit warnings. While the end result of my work is the chart patterns that I share with you, those ideas start with a fundamental review that includes current and forecasted growth profiles.
For example, CVI that I highlighted in Mosaic Chart Alerts has seen the past three quarters average 60% sales growth and triple-digit earnings growth. The stock also ranks well on analyst revisions for earnings estimates.
That stands in stark contrast to the profit warnings we’ve seen from companies like Amazon and Meta, which were among the leaders of the last bull market. The best growth companies and sectors in the stock market rotate, and I believe you must adapt as well.
Meanwhile, those same growth stocks I mentioned above are starting to roll back over, like with AMZN. Here’s the four-hour chart below to show the detail around the loss and back test of the $105 level. A loss of the $90 support level would signal the next down leg.
I’ve also written about how to take advantage of the turmoil in the crypto space with related equities. I’ve highlighted COIN here in Mosaic Chart Alerts, recently posted about MARA here, and now want to mention another crypto-linked stock that flies under the radar.
That is with CUBI, which has created this bear flag pattern. I’m watching for a breakdown below $30 to trigger a short signal.
That’s all for this week. While the recent pullback in longer-dated yields have helped spark a relief rally, the underlying structural issues facing the economy and profit outlook have continued to deteriorate. For long setups, I’m focusing on companies growing the top- and bottom-line regardless of those challenges, while short setups largely include the prior bull’s high-flyers.
I hope you’ve enjoyed this edition of The Market Mosaic, and please share this newsletter with anyone you feel could benefit from an objective look at the stock market.
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Disclaimer: these are not recommendations and just my thoughts and opinions…do your own due diligence! I may hold a position in the securities mentioned in this newsletter.
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