5 Early Warning Indicators For US Stocks

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5 Early Warning Indicators For US Stocks

“It’s quiet out there… Too quiet…” So goes the old movie line, usually spoken by a laconic hero, surveying the landscape and wondering when the enemy will arrive.

US equity markets feel much the same way at the moment. A few weeks ago, the mood seemed outright bearish, or at least extremely cautious. Now, with the S&P and Russell sneaking up on their all time highs (and the NASDAQ through it) all is sunshine and light once again. “Too quiet” indeed.

So where are the war drums beginning to sound? We went looking through our list of early warning sensors, summarized here, with a few links for lesser-followed measures in case you want to see more.

#1. Dollar strength as stock market challenge. The greenback is at one-year highs using the DXY Index, up 5.6% from its March lows. The dollar is also +4.6% on the Chinese yuan for the year and 8.0% from the March lows.

Takeaway: over the short term dollar strength is typically a headwind for US stocks. At the same time, we’re still 7.4% away from long-term (5 year) highs on the DXY. Given the differences in US/rest-of-developed-world economic growth and central bank policy, further dollar strength is likely. And therefore not enough of a surprise to roil US equity markets, as long as it happens slowly.

#2. US 10-year Treasuries: “Too, too quiet?” Actual volatility in long-term Treasuries has plummeted in the last 30 days, down to levels last seen in October/November 2017. This, in conjunction with a sub 3.0% yield, has certainly helped US stocks find their footing.

Takeaway: the current low volatility regime in Treasuries can’t last forever. A slow melt-up in yields is the best-case scenario for stocks, consistent with a market reset to higher growth and inflation expectations. A gap up (from an inflation scare) – or down (from an exogenous shock, most likely) are the downside cases.

#3. Italian sovereign debt as Eurozone risk monitor. Italian bonds haven’t been the same since the election-inspired volatility back in May. Two-year debt there still yields +0.59% versus -0.65% for German debt and -0.54% for French bonds. Ten-year debt yields 2.51% versus 0.33% for German Bunds and 0.62% for French long term paper.

Takeaway: sovereign debt investors remain wary of Italian paper, even over a short enough horizon to make any “Italexit” irrelevant. US equities don’t seem to mind, but it is a space worth watching.

#4. TED Spreads as indicator of global dollar shortage. Earlier in 2018 there was plenty of chatter about how Fed rate hikes were sucking dollars back to the US and away from emerging markets and the offshore Eurodollar market. Treasury-Eurodollar spreads almost tripled from 22 basis points in mid-February to 64 bp in mid-April. TED spreads are now 41 bp, well off those highs.

Takeaway: like Italian debt spreads, this is one market concern that has gone to ground in the last 30-60 days. But also like the prior point, levels are not where they were at the start of the year. That indicates a residual market concern, but for the moment it seems contained to emerging market debt and equity.

See the chart here: https://fred.stlouisfed.org/series/TEDRATE

#5. US Corporate Bond Spreads as indicator of risk appetite in credit markets. It has been a tale of two markets this year in terms of corporate debt:

  • Investment grade spreads have widened from 1.28% at the start of 2018 to 1.54% today. The YTD peak was earlier this month at 1.63%, so at least things are moving in a more market-friendly direction now.
  • High yield spreads are actually slightly tighter since the start of the year, at 3.56% now versus 3.63% on January 1st. In between then and now they have meandered between 3.2% and 3.8%.

Takeaway: tight high yield spreads are the unsung heroes of the continued rally in US stocks, signaling steadfast “Risk on” sentiment even as stocks occasionally lost their nerve. That market continues to show confidence, even today.

Investment Grade spread chart here: https://fred.stlouisfed.org/series/BAMLC0A4CBBB
High Yield spread chart here: https://fred.stlouisfed.org/series/CPFF

Final thoughts on all this: when we look at the overall investment climate through these five indicators it is easier to see why US stocks have pulled themselves out of their funk. At the same time, they mostly are not back to calmer pre-February levels. Still, they do not signal enough potential turmoil to shake us from our positive outlook on US stocks.