Tuesday , 5 July 2022

Relax! There Is Still Significant Upside Ahead For the Stock Market

The market is full of valuable information – you just need to know where to look – [so,] this article provides valuable information regarding recession fears and how you should manage your portfolio during these challenging times.

This version of the original article by Robbe Delaet has been edited [ ] and abridged (…) to provide you with a faster and easier read. Also note that this complete paragraph must be included in any re-posting to avoid copyright infringement.

The US 10-2Y Yield Curve

The US 10-2Y yield curve is a powerful indicator of how the economy will evolve in the future.

Correlation 10-2 Year yield spread and US recessionInsider Opportunities based on FRED data

Today’s inversion of this curve tells us that the economy will likely be red-hot in the near term, followed by a recession due to monetary tightening. This recession will likely occur in 8-22 months from now. Should we therefore be bearish about the stock market in 2022 and beyond? Not necessarily, based on two reasons:

  1. An inverted yield curve has historically been followed by strong stock market gains in the short-to-mid-term. On average, the stock market rallied by 16.9% and 10 months before a downturn occurred.
  2. An economic recession is not necessarily a disaster for stocks in the long term either…

The Stock Market

#$$4$The visualization below gives us a good indication of what might happen with the stock market in the coming year given the inverted yield situation and, astonishingly, only 1/7 times in history has an inverted yield curve been a strong short-term sell signal. In the other six cases, becoming highly bearish about the stock market after a yield curve inversion has not worked out well.

Correlation S&P 500 stock market return and 10 year - 2 year treasury yield spreadInsider Opportunities with FRED and Finance Yahoo data

Market Sentiment

Yes, you should definitely be aware of long-term economic cycles, however, there is one thing in the market which should be much more important for your investment decisions: market sentiment (fear & greed). Understanding this will improve your returns dramatically.

The market moves in cycles based on sentiment and, at Insider Opportunities, we track this sentiment with our IO Opportunities & Risks Index and such is shown in the chart below.

IO Opportunities & Risks Index historical data, alternative for Fear & Greed IndexSource: Insider Opportunities

A high-greed read-out (indicated in red) has historically been followed by very weak returns for the small-cap Russell 2000 Index. In contrast, a high-fear read-out (indicated in green) has historically been followed by very strong returns.

The data is perhaps even more impressive when visualized in a table. As you can observe below, the IO O&R Index has predicted future stock market returns very accurately, especially in the mid-to-long-term. For example, the average read-out below 5 was followed by a 1-year return of 28.3%. Meanwhile, a read-out above 95 was followed by a negative 1-year return of -4.94%.

IO Opportunity & Risk Index correlation with future market returns, Insider OpportunitiesInsider Opportunities; data since 1997

How does this translate to today?

If the yield curve inversion would have been accompanied with high greed in the market, similarly to early-2000 when the Nasdaq collapsed quickly, I would be highly bearish on the markets but, luckily, this is not the case…

What’s next?

Our O&R Index is currently trading at 12.9, which indicates that there is still significant upside ahead as investors become less fearful. A similar scenario to 2006 and 2019 is definitely possible: continued gains despite looming recession fears…

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