Reversing of Inverted Yield Curve not Bullish for Stocks- Recession Still Possible

By The Curmudgeon

Curmudgeon's Liquidity and Leverage article postulated that the money spigots were slowly being turned off and predicted the unwinding of many leveraged bets (CDOs, carry trades, liquidation of new derivatives, etc.) as a result.  Shortly thereafter the news confirmed that credit conditions were being tightened for home loans and that the funding for buyouts was not going to be available any time soon.  That precipitated waves of selling on Wall Street.

Now some pundits have opined that the reversal of the inverted yield curve has negated any  possibility of recession.  The claim is  that a recession and resulting decline in corporate earnings has been avoided. So they are sounding the "All Clear" signal for stocks.  However, a look at past recessions reveals that a reversal of an inversion typically occurs prior to the economic decline- ranging from 6 months to over a year in advance. So there is a good probability that earnings will decline and push stock prices lower in the intermediate term.  The key is how the consumer will react to the housing and credit market deterioration.

The current credit market conditions could certainly cause a recession, triggered by a big decline in consumer spending, which accounts for 70% of U.S. GDP.  Very, very quickly, the liquidity tap is being turned off by institutional lenders and bankers. The marginal borrower is being denied credit, even if he is creditworthy. The resulting credit crunch is reverberating throughout the financial system, playing havoc with the prices of many debt instruments and equities that are tied to them.

The key unanswered question is whether the credit market grid lock will spread to the real economy and trigger a recession.  A related imponderable is if the Fed will cave in to financial market pressure and reassert the Greenspan (now Bernanke) put.  Will the Fed consider bailing out a large financial services or private equity firm that is on the brink of collapse (remember the LTCM rescue package)?  Will they lower rates prematurely, despite inflation being higher than the target range?  We will need to carefully watch how the Fed reacts to financial market falls in the weeks and months ahead.

Deteriorating stock market breadth was one of the factors that led us to anticipate the current stock market decline.  While the Dow was hitting new highs in mid July, there were more declining issues then advancing for most of the week.  An examination of the current Advance/Decline Lines shows the fade is continuing, and is particularly prevalent in the small cap indices.   With the Dow and S & P 500 both up 2.2% and 2.4% respectively today, the A/D line was marginally positive on the NYSE and negative on the NASDAQ.

            NYSE    NASDAQ
Advancing   1,787   1,450
Declining   1,553   1,614
Unchanged     65      107

While we continue to believe that any stock market decline will be limited due to low note and bond yields, we do not see a recovery to new highs anytime soon unless more stock participate in the advance.

The Curmudgeon

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartrered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.