Both coronavirus and OPEC are in the headlines… but I believe there is a bigger story driving the stock market.

It’s actually a story from last year that many investors and analysts seem to have forgotten about. It’s the yield curve.

Last March, I wrote, “The curve is inverted from 6-months to 10-years, an indicator that a recession is likely. Stock prices often fall during recessions, and the average bear market in a recession results in a loss of more than 30% in the S&P 500.”

The yield curve is a graph showing current interest rates for various periods. Normally, the graph slopes upward because longer-term bonds carry higher interest rates. For example, a 15-year mortgage has a lower interest rate than a 30-year mortgage because there is less risk over 15 years.

One reason the yield curve inverts is because businesses are worried about the risk of a recession. They are unwilling to borrow to fund new investments, and this results in lower interest rates for longer-term loans. Lower interest rates are a sign of reduced demand and are, in effect, an effort by lenders to encourage borrowers.

The Yield Curve, Then And Now

In the chart below, we see the yield curve using 10-year Treasury notes and 3-month Treasury bills was inverted last year. It briefly inverted again this past week.

Source: Federal Reserve

We see these inversions ahead of a recession, as the next chart shows. This is a chart showing the yield curve before the 2008 recession. Notice the second inversion as the recession was beginning, potentially the same pattern we saw this week.

Source: Federal Reserve

A very brief second inversion preceded the 2001 recession (below).

Source: Federal Reserve

The signal was about seven months too early in the 1990 recession (below).

Source: Federal Reserve

The yield curve is not the only indicator of an imminent recession. The stock market’s recent advance and decline is also consistent with a recession.

In July, I told you, “History also shows that the stock market often races higher in the months before a recession. If history repeats, we could see a sharp rally in stocks, pushing the S&P 500 to a level near 3,500. This would most likely be followed by a bear market, but there is significant potential upside before the next bear market.”

The market’s rally from October to February was most likely a blow-off top. Last week, the S&P 500 failed to hold its 200-day moving average (MA), the blue line in the next chart.

At the recent lows, the S&P 500 was more than 15% below its high. That’s a significant decline, but history tells us we are less than halfway to the bottom.

Action To Take

The yield curve signaled the recession a year ago. The market’s surge in the fourth quarter of 2018 was a warning that the recession was drawing near.

Coronavirus was a surprise, but it came as the economy was slowing. It might very well be the trigger for the recession because the economy was in a precarious state and vulnerable to a trigger.

My initial target for the S&P 500’s bear market is 2,375, a 30% decline. It could ultimately go even lower. We will most likely see short-term rallies along the way down, but we may also get there fairly quickly. As the bear market unfolds, I’ll adjust my target.

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