Are Markets Getting Too Far Ahead?

Caution

The function of trading markets is to discount future results. As with any predictive exercise, one should recognize judgement mistakes will happen. One major predictive mistake is to get too far ahead of future results, often caused by not recognizing the ebb and flow of future events prior to conclusion.

Connecting many current predictions, we are absolutely going to go thru the following stages, all in predictable time periods.

Bear Market > Recession > Political Change > Bottoms >

Recovery > Buying Opportunities > Bull Markets

Note: there was no mention of mistakes and inconsistences.

Incomplete evidence is popping up suggesting the stock market will return to form and force us to be humble. My best guess is that before we get a formal call that we have entered a recession, we may go through a somewhat violent trading surge first. It will cause some to question the inevitability of a meaningful recession, although the result will not preclude a major decline from causing a restructuring.

Current Evidence

1. For the last 2 days of the week, major US stock indices explored lower prices but closed above their lows.
2. While the Dow Jones Industrial Average (DJIA) had only one rising session, the Dow Jones Transportation Index had two. (I believe the transportation index is a better judge of current conditions than the DJIA, which has more of a future orientation)
3. Last week, there was only one stock price index which rose out of all the S&P 500 indices. (This is unlikely to be repeated regularly.)
4. The number of shares traded on the NYSE had more volume for the week than the NASDAQ, with 17 million shares declining and 14 million rising. The volume of trading on the NASDAQ was essentially even, with 14.58 million advancing and declining. (As expressed in the past, the NASDAQ has more active traders than the NYSE and consequently is more useful for predictions.)
5. The JOC-ECRI industrial price index declined -3.4% this week.
6. Market analysts often believe the results of the American Association of Individual Investors (AAII) survey should be viewed as a contrarian indicator. This week, the AAII bearish indicator was an extreme 58.3%, up from 46.9% the prior week.

I believe the odds favor more upside than downside well into July. The Atlanta Fed’s current GDP reading may soon indicate a flat or contraction estimate, with a possible confirmation by the Federal Reserve on July 28th. (The 35th anniversary of “Black Monday”)

Fixed Income Signals

Stock investors have learned to pay attention to price movements in the fixed income markets, which tend to be more sensitive to price risks than stock jockeys are.

While the yield curve has been rising sharply for short to five-year maturities, it is essentially flat for five to thirty year maturities.

The collective bet is that inflation will not rise beyond five years. (What does this say about the Presidential election of 2028?)

One sign a bottom has been reached is when an important group of investors capitulates to the current trend, selling out of their positions quickly.

Some believe investors in credit instruments have capitulated and sold off their credit instruments, a move not echoed in the high-quality bond market. This week, the largest net redemptions in the Exchange Traded Fund (ETF) market were high current yield funds (pejoratively called “junk bonds”). The redeemers were reacting to a perceived increase in credit risk.

The concern bridging the fixed income market and the stock market is the belief in book value on corporate balance sheets. Book value is based on historic cost less depreciation of fixed assets, which can only be written down, not up. One popular “value investing” approach is to buy shares of a company whose price is below book value. However, if current stock prices do not adequately price book value due to changing conditions, the current book value discount may not be accurate.

Thus, some of the fears expressed in the fixed income world can travel into the equity world, making some stocks risky

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.