RELATIVE STRENGTH NEWSLETTER - 1ST QUARTER 2023

Relative Strength Update

Another eventful quarter for the markets. At the beginning of the year most market pundits were looking for continuing softness in the inflation data and negative earnings revisions. Many spoke of a “kitchen sink” quarter where companies take advantage of reduced earnings expectations to throw out a lot of bad news- a quarter to clear the decks, so to speak. The expectation was for a market that was “choppy to down”. Oil prices were under pressure but expected to rebound on the reopening of China following their COVID lockdown. January began the quarter with a stronger than expected rally and, albeit primarily in the areas that were hit hardest in 2022 (Technology and Consumer Discretionary), continued its strong momentum into early February as the Federal Reserve only raised rates 25 bps and Fed Chair Powell’s post meeting comments were interpreted to be slightly more dovish.

The market strength began to unravel a bit as we moved into February with the release of hotter than expected inflation numbers in the January CPI data. Geopolitical angst returned as we watched the slow-moving surveillance and subsequent shoot down of a Chinese spy balloon. The Lowcountry and much of the nation was gripped by the Murdaugh trial- a likely tremendous boon to the local Walterboro economy but a huge distraction for everyone else.

In early March we finally received some good news on the inflation front with the release of the February CPI data. Unfortunately, we were not able to enjoy it for long as trouble began to emerge in the banking sector. First it was Silvergate Capital, followed in short order by Signature Bank, Silicon Valley Bank and finally (we hope), by UBS’ takeover of Credit Suisse. This turmoil gave the Fed pause and they only raised rates 25 bps rather than the 50 bps that was expected only a couple of weeks prior. Mixed messages from the Federal Reserve and US Treasury officials, fear of deposit flight and potential contagion created extreme selling in virtually all bank stocks- large and small. The result is that the bank crisis and related tightening of financial conditions may have done the Federal Reserve’s job for them, leading our market strategy team to reduce their expectations for further rate hikes and the subsequent terminal Fed Funds rate. Our expectation is for inflation to continue its downward trajectory and that we are much closer to the end of the rate hiking cycle than we were at the beginning of March. Our market strategists’ expectations are for a continued range-bound market (S&P500 3,700-4,200). It is likely in the short run that we don’t see much market upside but not that much downside either. From a Relative Strength standpoint, many of last year’s Relative Strength laggards rallied to begin the year. It’s too early to tell if this is the beginning of a new trend or just reversion to the mean. Regardless, we will follow our indicators and favor long-term trends. We appreciate your continued trust in us and, as always, feel free to reach out with any questions.

Did You Know – The Two/Ten Spread

We take a look at what the widening of the two-10 spread has historically meant for the S&P 500.

As we have briefly mentioned, the spread between the 10-year and two-year US Treasury yields, which has been inverted since last summer has widened (i.e. reversed course) rapidly recently as short-term yields declined more quickly than long-term yields.

Of course, inversion of the two-10 spread is often cited as a recessionary indicator. The idea is that in a normal environment, the yield curve is upward-sloping, i.e., longer-term rates are higher than short-term rates. When short-term rates, like the two-year, are above long-term rates, like the 10-year, the curve is inverted. If we accept the theory that long-term yields reflect expectations about the future of short-term rates, then an inverted yield curve implies an expectation that rates will decline in the future. And when do we typically see the Fed lower interest rates? During periods of economic slowdown/recession. One scenario is that the Fed raises rates, to curb inflation for example, but does so too rapidly, inducing a recession.

If an inversion of the two-10 spread is a negative sign for the economy, intuitively it would make sense that the widening of the spread should be positive. However, the widening of the spread after a period of inversion has often been followed by a recession shortly thereafter. So, in something of a catch-22, an inversion of the two-10 spread is bad, but once it has inverted widening of the spread is also bad. The image below from Bloomberg, shows the two/10 spread with the red bars representing periods of US recessions.

OK, perhaps we just have to accept that once the yield curve inverts, a recession is a foregone conclusion. But, even if we accept this as fact, as investors, our primary concern is not the economy, but the market. And though the two are related, they are not equivalent as the market, for its part, tends to act as a leading indicator of the economy. For example, while the market found a bottom in March 2009, the US economy did not emerge from recession until June. That’s why today we wanted to take a look at what the widening of the two-10 spread has historically meant for the S&P 500.

Although it seems straightforward, judging the inversion of the two-10 spread involves some subjectivity. As a recessionary indicator, we’re most often concerned with when the yield curve was inverted for an extended period. There have been periods where the spread between the two- and 10-year yields briefly inverted only to quickly revert to a normal state, like in 2019 when the two-10 inverted for three days in August 2019 before widening again and did not invert again until 2022. There have also been periods when the curve was inverted for an extended period, widened, and then inverted again for a few days – for example in 1981, the two-10 inverted for an extended period and then uninverted in late October, and then reinverted for a day here and there before reinverting for an extended period in early 1982.

All of this is to say, that the list of inversion dates provided below should not be considered authoritative. We have tried to capture the periods when the two-10 spread went negative for extended periods, but the actual precise start and end dates of periods and what constitutes an “extended” period are open to interpretation. Additionally, there is no hard-and-fast definition for what constitutes a significant widening of the spread after it has inverted. Therefore, we have measured the forward performance of the S&P 500 using two methods – from the date the yield curve reverted to a normal state after inverting and from the date when it reached its maximum level of inversion during that specific period.

Looking only at the performance numbers, there doesn’t seem to be much of a discernible trend. There are periods of strongly positive performance – and strongly negative performance. However, we can see that there was a significant drawdown going forward for most of the periods. For example, from the end of the 1980-1981 inversion in October 1981, the market was up almost 44%. However, looking at the one-year return from the maximum inversion of that period, we see the market was down -7.4%, indicating that there was a drawdown followed by a strong recovery. Similarly, the S&P was down more than -15% following the end of the August - October 1989 yield curve inversion but was up 9.2% in two years, once again showing a drawdown and subsequent recovery, which roughly lines up with the overall economy as the US was in a recession from July 1990 – March 1991. The 1980 – 1982 numbers are a little trickier to pin down as the US had double dip recessions from January 1980 – July 1980 and July 1981 – November 1982.

Following the 2000 and 2006 inversions, we see much larger drawdowns, with these periods being associated with deeper recessions. As with many things surrounding the market and the economy, the data isn’t clear on exactly what the inversion and widening of the yield curve mean for forward market returns. Assuming a recession is imminent, we shouldn't be surprised if the S&P experiences a drawdown sometime in the next year. As to how large a potential drawdown might be, it appears the answer to that question depends largely on how deep the (potential) recession is.

The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of the author and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Diversification and asset allocation does not ensure a profit or protect against a loss. Holding investments for the long term does not ensure a profitable outcome. US Treasury securities are guaranteed by the US government and, if held to maturity, generally offer a fixed rate of return and guaranteed principal value. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Inclusion of this index is for illustrative purposes only. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transactions costs or other fees, which will affect actual investment performance. Past performance does not guarantee future results.