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.

Long EAFE, But Maybe Not Yet

The relative turn from S&P 500 (Nasdaq) leadership to MSCI EAFE (MSCI Emerging Markets) leadership has probably started, but the first stage might still be bearish for stocks. At least it was in the 2000 and 2008 turns...

SPY-EFA Ratio Threatening Breakdown

If this rolls over and drops, it's a major signal for the markets. U.S. stock market leadership is over and it is either the start or end of the bear market.

What do you think? A new bull market is starting along with a new U.S. dollar bear market, led by non-US developed markets or a major top in the U.S. markets is about to pick up downside steam? SPY has way more tech exposure than developed markets, so if bearish, it hints at a resumption of Nasdaq leading the markets lower. If you notice the stochastics below as well, SPX-EAFE ratio bottomed in February 2000 and peaked again in October 2000. This time it peaked in December 2021 and bottomed in February 2023.

Here is EFA versus EEM for comparison. Looks like a massive base in favor of developed markets.

Elevated Squeeze Risk vs Baizuo Freight Train Headed Off Cliff and h-Patterns Everywhere

Squeeze risk is currently elevated, but the caveat is crashes happen in oversold conditions. You don't want to be opening short positions here unless you have tight stops or are watching closely. That said, intraday reversals such as we saw on Thursday and Friday can reset this equation in a day or less. Short the right rip and one need not cover until the bottom.

On the other side of squeeze risk is the reality of Europe's energy situation. Using the Elliot Wave as a framework, here are the stages of accepting the European energy crisis.

1. Sanctions/Russia cuts supply. Uh oh!

2. Priced in, not that bad.

3. The market doesn't realize how bad winter will be. Euro must devalue XX percent based on printing needs. (We're here now.)

4. Priced in, won't be as bad as expected.

5. Final panic over energy or collapse in currency or panic in stocks, or all three.

The euro made a new 52-week low on Sunday night. The futures chart, along with many assets such as weaker stocks and crypto, has formed the dreaded h-pattern. It's the prelude to a bear squeeze or resumption of selling to a new low. Since I believe this is a bear market, the h-pattern will be more friend than foe to bears from now on.

My view is macro and psychology overwhelm technicals in Wave 3. Bears are already all-in by some measures, but my expectation is commodities will implode and cause panic in the inflation trades.

There's also something very wrong in how the market is pricing Europe's energy crisis in my opinion. Or I'm very wrong and it isn't nearly the crisis everyone is making it out to be. What's the truth? 

Most people still pay attention to major media and the media are 100 percent behind the Baizuo governments of the West. Markets are down, but investors remain sanguine in the face of what is coming because "all is well" propaganda is running 24/7. My hunch is something will break the facade such as a sudden, impossible to ignore drop in economic output or company earnings. European companies are shutting down left and right because power costs are finally filtering through the broader economy. It is akin to a permanent lockdown or a lockdown with no expectation of exit. 

If energy costs are permanently higher, then economic output is permanently lower, and equities must reprice far lower. Even without any of these problems, a major bear market is possible. Add higher energy into the mix and a 60 percent or higher decline (adjusted for inflation) is a conservative target.

Hussman has the projected 12-year return at something more than negative 3.5 percent annualized. That means a portfolio would be down about 35 percent 12 years from now. Stocks don't slide year after year though, they plummet and then climb back. How low would stocks have to go to achieve that return over 12 years? One way it to lose close to 80 percent up front and then recover with a couple of 30 percent and 20 percent annual returns mixed in. History says plunging prices are more likely than not.

RUSSIA INDEFINITELY SUSPENDS NORD STREAM GAS PIPELINE TO EUROPE: FT

Markets are wildly optimistic about how this will shake out. I'm not talking about what people are saying, but what asset prices are saying. This is barely priced into stocks. Or as I like to see it, we're att the starting line of the plunge.

I could see those indexes touching support on nothing else except a bear market similar to the 2000s dotcom bust. Things are far worse though, unprecedented since maybe the Arab Oil Embargo of the 1970s. EZU at $15, retracing all gains since 2008, is a real possibility. A nearly 60 percent drop from here. 

Buy the Reversals of Fortune

Germany was a leader. It should turn into a laggard. This doesn't mean long Greece, but probably at least one of the PIIGS will outperfrom for awhile.

WTI in Euros

Doing the chart in Brent produces the same result. The Eurozone is already paying near 2014 highs for oil, around $100 if we were talking about the U.S. If the dollar continues rising with crude oil, European markets are going down.

Foreign Stock Freefall

Relative reversals typically occur during a trend change. The MSCI EAFE peaked versus the S&P 500 Index in June 2008. It previously bottomed in January 2002.

ERmerging markets look even worse.

EFA Ooof

Will it complete? The target is around $70 if it does.

Inflation Bu Hao, Very Bu Hao

If you want to know why I'm bruised, but as excited to be shorting as I was a month ago, I give you exhibit A. If you want to know why I think inflation can wreck stocks fast, here is the real earnings yield on stocks and the 46 percent bear market from 1973 to 1974 and the bear market low of 1982 and the fact that today's earning yield is lower. Now you know why ARKK holdings have been annihilated. Stocks with no or low earnings, with a lot of hype about back-loaded growth get traded like a 30-year treasury bond. The whole market is devaluing in real terms and investors are still bidding prices up on an inverted assumption about the direction of prices under higher inflation. I can't imagine a better setup with reality and assumptions so completely divorced.

Bloomberg: BofA Says S&P 500 Real Earnings Yield is Lowest Since Harry Truman Was President

The S&P 500 Index currently has a real earnings yield of -2.9%, meaning that without continued growth in company results, investors would lose 2.9% when adjusted for inflation, the strategists led by Savita Subramanian wrote in a note on Wednesday. “Last time the real earnings yield was this negative was 1947.”

In each of the previous four times that real earnings yield was negative, a bear market was the result, according to the strategists, who advised investors to seek refuge in inflation havens, such as energy, financials and real estate. Expectations that inflation will moderate from 6.2% to 2.5% over the next 12 months may prove too optimistic, as that would imply the sharpest drop in four decades, they said.

I don't think any of those will prove to be safe havens, at least not initially. Natural gas and producers are an exception because it can be uncorrelated. I do think enegy will greatly outperform, but energy stocks may also fall in price in a bear market. I'm increasingly biased towards holding futures on the commodities. I could be wrong about energy stocks, I'm not pounding the table there, but I would be surprised if energy stocks went up in a bear market. (I'm also still leaning to the first wave of a possibly decade-long churning bear market to come via deflationary forces.) Actual physical real estate may hold up and REITs may outperform relative to stocks. Financials could get wrecked if the Fed loses control and inflation is higher for longer, and long-term rates rise too quickly as a result. Maybe I'm wrong about financials because in relative terms it looks undervalued compared to the S&P 500 Index, but as a bear, that only makes me think the losses in tech are going to be insane.

International will probably be a bloodbath to start if the dollar goes higher.

The Top

Note: Images are largest if you right-click and open in a new tab.

Here's the market top pattern again. I believe it came from Solar Cycles. The RSI and chart itself are more compelling to me than the ADX, but I see a simliar relatinoship between the peak periods.

The chart shows the Dow divided by the long bond price. It is strongest when stocks rise and bond's fall, as would happen during an inflationary expansion. Investors who expect some type of massive inflation that benefits equities at least relatively, would expect something totally new from the past 20+ years of history: a chart that keeps going up at an accelearting rate. Bears anticipate whichever way bonds go, equiites will do worse. Since it is a ratio, a collapse in both bond and stocks could leave the ratio elevated despite incredible losses. Right now I expect a retrace down to the horizontal line during the next bear market. If bond yields make a new low (bonds a new high) stocks might hold above the 2020 lows. Reminder: A test of the 2020 lows would take stocks down 50 percent. If interest rates remain elevated, i.e. bonds go lower, then a retrace of the ratio to the horizontal would entail lows that exceed March 2020, perhaps even all the way back to the 2000 peak on the S&P 500 Index.

Here's the chart with the COMPQ and SPX.

I checked the MSCI EAFE too. Interesting range there that speaks more to the weakness in Europe and Japan.

SPY to EEM Ratio and SPY-EFA