How the Fed will impact stocks over the next year

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Today the Fed signaled that an interest rate cut is coming in the future.  The only uncertainty is “when” – will the rate cut occur in July, or later? Today’s headlines:

  1. How various markets respond to rate cuts
  2. What SUSTAINED yield curve inversions mean for stocks and gold
  3. Stock market’s quick recovery from correction territory
  4. Dow transports lagging badly
  5. Copper’s death cross

Go here to understand our fundamentals-driven long term outlook. For reference, here’s the random probability of the U.S. stock market going up on any given day.

How various markets respond to rate cuts

The implied probability for a rate cut in July is now at 100%, which means that many market participants expect the Fed to cut interest rates soon.

Here’s how various markets performed after the first rate cut. This is the S&P. You can see that the S&P tends to perform poorly in the first month after a rate cut.

Here’s gold. Gold tends to perform poorly 3 months later, but better 1 year later. Notice how the last 2 “first rate cuts” (September 2007 and January 2001) saw gold rallying 6-12 months later. This is partially why some traders are bullish on gold right now. In their mind, the best way to trade a recession is to go short stocks and long gold.

Here’s what happens next to the U.S. Dollar Index when the Fed cuts rates for the first time. 1 year forward returns lean bullish.

Here’s what happens next to the 10 year Treasury yield. Long term interest rates almost always fall 6 months later.

Here’s what happens next to oil.

Sustained inversion

Puru made a very good observation. In a nutshell, the 10 year – 3 month yield curve is on the verge of being inverted for 5 consecutive weeks.

Sustained inversions are more important than brief inversions, which are more likely to be false bearish signals. For example:

  1. 2006-2007: sustained inversion, followed by a recession and bear market
  2. 2000: sustained inversion, followed by a recession and bear market
  3. 1998: brief inversion, false bearish signal

Here’s what happens next to the S&P when the 10 year – 3 month yield curve has been inverted for 5 consecutive weeks (i.e. right now)

The S&P’s forward returns start to deteriorate at the 3-6 month later point. Here’s the S&P’s maximum drawdown.

The yield curve is a long term indicator for risk:reward. It isn’t for short term (or even medium term) market timing. This demonstrates that over the next 1-2 years, the risk of a big recession-driven drawdown is significant. In my opinion, the main risk lies in 2020. But we need to consistently re-evaluate our beliefs as time goes on and new data is released.

Here’s what happens next to gold when the 10 year – 3 month yield curve has been inverted for 5 consecutive weeks.

While this isn’t an immediately bullish sign for gold, the 1.5-2 year forward returns are more bullish than random.

NASDAQ’s quick recovery

After making a -10% correction (using daily CLOSE $), the NASDAQ has recovered very quickly. It is now within -2.5% from its closing high in early-May.

Here’s what happens next to the NASDAQ when it makes such a quick recovery.

Most of the historical cases were in the late-90s. Even though this was late cycle, the stock market still went up another year.

Dow transports are lagging badly

The Dow Jones Transportation Index has lagged the S&P 500 badly. While the S&P is near all-time highs, the Dow is more than -10% below its highs.

Are lagging Dow Transports a consistently bearish sign for stocks?

No. The last 2 times this happened was July 2015 (before the August 2015 crash) and October 2007 (before a bear market).

But before that, it wasn’t such a bearish sign.

Here’s 2015:

Here’s 2007:

Copper’s death cross

And finally, copper made a “death cross”, whereby its 50 dma fell below its 200 dma

Historically, these death crosses were slightly bearish for copper in the short term (1-4 weeks later), and bearish for copper 1 year later.

We don’t use our discretionary outlook for trading. We use our quantitative trading models because they are end-to-end systems that tell you how to trade ALL THE TIME, even when our discretionary outlook is mixed. Members can see our model’s latest trades here updated in real-time.

Conclusion

Here is our discretionary market outlook:

  1. The U.S. stock market’s long term risk:reward is not bullish. In a most optimistic scenario, the bull market probably has 1 year left.
  2. The medium term market studies (e.g. next 6-9 months) are mostly bullish.
  3. Market studies for the next 2-3 months lean bullish.
  4. Market studies over the next 2-4 weeks are mixed.
  5. We focus on the medium-long term.

Goldman Sachs’ Bull/Bear Indicator demonstrates that risk:reward does favor long term bears.

 

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