Bear Rally Over? Yield Curve and VIX Turn Higher

It has been a long and winding road in this bear market. Yes, I still believe a bear markert is underway until new highs are made. I haven't been tactically bearish on the market over the preceding months, onyl taking some small swings when setups looked good. Until those old highs are taken out, my bear market call from November 2021 remains intact.

First, the classic bubble chart pattern hasn't been violated:

A double-top is a valid expression of the "return to normal" phase. Bullish sentiment and speculative behavior return to near peak levels, propelling the major indexes or stocks into double-tops. Anecdotal, but cryptocurrency speculators believe a new bull market is underway. Bitcoin BTC has a pattern that is consistent with the classic top though:

Tesla, Google, Amazon and Meta all sport the classic pattern with no hint of an imminent double-top. The paradox stocks are Apple and Microsoft. Both have achieved new all-time highs. Their massive weight in the S&P 500 technology sector (nearing 50 percent at times) propelled that sector to a new all-time high in July. If I'm correct in my assessment, this will turn into an overthrow of a double-top pattern and not an extension of the bull market.

Industrials also achieved new all-time highs this year. Energy and materials made new highs in the second-quarter of 2022 and remain within striking distance of new highs.

I'll digress here and give the bullish argument over the longer-term. Assume for a moment the U.S. was primed for a recession around the time the coronavirus hit. The government then wrecked the economy and then flooded it with far too much stimulus. Even though there's no official recession in 2023, the U.S. government is running deficits on par with the fallout from 2008:

There's nothing bullish about that chart long-term. Growing deficits will increase inflationary pressure. Falling deficits could trigger deflationary pressure. Since stocks are priced for perfection, deviation out of the Goldilocks Zone will trigger price declines in all sectors at least for a time, barring an explosive move higher in energy as we saw in early 2022.

I don't want to belabor the valuation topic, but here is the price-to-earnings ratio divided by the growth rate (PEG) and the spread between investment grade corporate bonds and the Federal funds rate.

Going back the to the bull thesis: what if the government front-loaded stimulus and the bear market/recession doesn't materialize? In that case, either an extension of the bull unfolds or the transition occurs without the bear move. Both EFA and EEM, the developed and emerging market ETFs, bottomed in October 2022, with EEM having a little overthrow this year:

To wrap up the bull case: the government flooded the economy with stimulus, triggering a temporary inflation surge. Inflation settles back into the Goldilocks Zone, as does GDP growth, sub-2 percent for both. In the short-term bull scenario, stocks enjoy an extension with tech and other speculative assets resuming leadership. In the longer-term scenario, the transition to new leadership such as industrials, energy, commodities and foreign markets takes place without a major bear.

Back to the bear scenario, one of the strongest signals for a recession has been the inverted yield curve. It doesn't indicate an imminent recession, rather it signals the pre-recesesionary stage. The actual recession comes when the yield curve steepens. Going back the past four decades, this has always occurred when the Federal Reserve slashed rates. Right now, the yield curve is steepening because long-term bond yields are rising faster than short-term yields. It is a small move at the moment, but the spread has made a higher low, indicating the final low might be in.

The 10-year treasury yield has a bullish formation that may or may not complete. If it completes, then higher long-term rates will sink financial asset valuation and could indicate a stagflationary recession. The 30-year mortgage would be on its way towards 10 percent, a level that would almost assuredly kill home prices too. On the flip side, a traditional steepening via Fed rate cuts would be another bear market and recession like we've seen in 2000 and 2008.

The decline in the VIX has been a hallmark of this bull market. The VIX has fallen below the level reached at the November 2021 peak, indicating fear is gone. Here's the VIX overlaid with the 2s10s spread:

VIX isn't a great indicator in that it tends to be coincident with the 2s10s, but a rising VIX indicates rising fear, likely because there's bearish action in parts of the market ahead of the full-blown bear. Here's a look at when the VIX bottomed ahed of prior bearish periods:

There will be bearish trades emerging very soon if the yield curve has finished inverting and moved into steepening. Ditto if the VIX follows it higher. With September and October coming up, the calendar supports a market top scenario here. New highs on the major indexes will invalidate the bear scenario, as will a falling VIX. If the 2s10s inverts further or moves sideways, it will indicate no imminent economic pressure. If the 10-year yield fails a breakout for instance, the yield curve might invert further while the broader stock market interprets the falling yield as disinflationary and therefore bullish.