In the process of observing the markets and how they have moved on news over the past year combined with reading several books written over the past 30 years that captured what people knew (or thought they knew) at that time I have developed a sort of unconventional market outlook because I believe that the indicators that used to work no longer do, at least as well as they used to. That shouldn’t be too surprising in and of itself because markets evolve and learn to discount information and then look for the next thing that will tip them off to the future earnings of each company.

This is why cyclicals like Micron start falling when earnings are great and start rising when things are terrible. I’m going to bet that wasn’t always the case. I’d bet that cyclicals at one time actually fell when things started to actually get bad. Then people learned from this and realized that to make a gain you had to make your trade before things started to get bad so the smart money would start taking profits while things were still good. This confuses most observers because people assume that prices should coincide with earnings themselves. But what actually moves the price of the stock is people actually buying and selling it. So those people start dumping to lock in the gains and look to deploy the money elsewhere. Timing this is impossible and most people are very bad at it. In other words they love to buy when it seems there isn’t an end in sight and panic sell when things look like they are terrible and can only get worse.

Anyway, I think things have fundamentally changed in some areas and wanted to write them down to see how they hold up in the future.

An inverted yield curve no longer matters.

I think people get way too focused on the inverted yield curve as a recession predictor. I am certain that 50 years ago this would have been an amazing thing to watch if you were clever enough to have done so. But those who were made note of it and the inverted curve became public knowledge and went under a microscope.

I think people don’t really understand why the inverted curve matters and I would go so far as to say the inversion itself doesn’t even matter besides showing the relative move across different timelines. No two people even seem to agree about what constitutes an inverted curve- the 3 month Treasury Note to 10 year Treasury Bond? Or was it the 2 year to 10 year?

What does matter is the trend in short term lending instruments. I like to watch the three month commercial paper rates and think even then it’s just one input and has to be judged in the context of overall rates and how high they are on an absolute basis. Does it really matter if short term rates have been rising if they are sub 3%? That’s still extremely cheap and pretty much ensures that money will be flowing around the economy for a while and there will be no credit crunch.

The bond markets no longer have any predictive ability.

There is a pervasive idea that bond markets are smarter than equity markets at analyzing data and predicting changes in the economy. I believe that was definitely true at one point because the bond markets are actually making statements about how much it costs to borrow money across many time horizons. Performing research on fed statements and things that would influence the future costs of borrowing used to be fairly rigorous and most equity traders were more focused on earnings statements than fed statements. Bond traders conversely were far more interested in those in control of monetary policy and then that all would be distilled into the prices of bonds. That’s why equity markets would look to bond markets for predictions about the future price of equities.

But then along came the internet and Twitter and 24/7 market coverage combined with far more visibility into what the fed and ECB were doing. I believe this eroded any informational advantage the bond markets had. Now the bond markets and equity markets are looking at the exact same things but for some strange reason the equity markets still look to the bond markets to predict future earnings.

It’s like a student cheating on a test. He may figure with a high degree of certainty that if the smart kid chose “B” as the answer that’s probably the correct answer, but he has no idea why it is. If one day the teacher publishes the multiple choice answers ahead of time but starts grading on essay answers instead, suddenly knowing the correct multiple choice answers has no value and getting the correct responses by copying the smart kid doesn’t add any points to the cheating student’s GPA.

The next bear market will probably come while rates are still low.

This is less of a general market observation and more of a short term prediction for today, but because of the way that markets discount information and the fact that equity markets have now gotten to the point of fully discounting fed policy decisions, people will start dumping stock before the fed makes a monetary decision. I’m still bullish for now, but I do think that equity prices could start falling almost inexplicably while earnings are still good and fed policy is still dovish. While the former would certainly be nothing new, the latter definitely would be. Remember that moving ahead of markets is extraordinarily difficult, some might say impossible, due to the inherent biases we all have and the way we react to how others react to news. I think it’s still possible but you do have to be willing to sell when it seems things can only go higher if the markets start coming down while things seem great. I don’t think the next bear market will be preceded by a major crash, it will be more of a slow bleed down over many months as institutional investors start trimming way out in front of fed policy changes and rotating back into value investments, the same ones that people have hated for the past few years. To me this could happen if inflation were to start ticking up and the market starts anticipating data that would make the fed hawkish and taking profits then instead of after a fed decision.

An alternate theory is that we melt up and have a typical blow off the top euphoric market that ends up tumbling down. But since that’s happened pretty recently with the late 90’s bubble and more recently with the housing and bitcoin bubbles, the markets are more attuned to those setups making their actual occurrence less likely. It sounds obvious but its very difficult to sense euphoria in others when its actually happening and not get caught up in it yourself. The same is true for panic. That’s why I find it so absurd when I hear people call for “capitulation selloffs” when markets are trading down as if they actually believe they are more sensible than everyone else and also won’t be in a state of panic when that selloff actually comes.

You cannot outperform markets by doing the same thing that everyone else is doing or thinking the same thing that everyone else does. If most people are bullish that will probably work for a while since markets can trend in a direction for a while, but eventually most people won’t come out ahead because when things change they won’t correctly recognize it. I believe that trading is much more game theory than economic theory.

You will be okay if you remember these three rules:

  • People are almost always wrong. Price action never is.
  • Sentiment always follows price.
  • Cut losses quickly.