I explain how death crosses in the stock market and inverted yield curves in treasury bonds could signal an upcoming recession and stock market declines in 2022. And how we can invest no matter what happens!
These two indicators have historically done a good job of predicting declines in the stock market and economic recessions. These recession warning signs could be pointing to another downturn in the coming months.
However, we shouldn’t get rattled because we can prepare for potential stock market buying opportunities based on these bearish trends.
While yield curves of US treasury bonds haven’t inverted yet, this is on the horizon because it could potentially happen soon in 2022 or latest by 2023.
What are death crosses?
Death crosses usually happen when a lot of stocks in an index are selling off. A death cross is a technical pattern on a stock or index chart showing when the short term moving average crosses below its long term moving average. A moving average is the average price of a stock or index over a certain period of time.
We often see death crosses when we compare the short term 50 day moving average (50 DMA) with its long term 200 day moving average (200 DMA). So when the 50 DMA crosses below the 200 DMA, that’s a death cross and is a bearish sign. The opposite of that is a golden cross when the 50 DMA moves back above the 200 DMA.
Right now death crosses are manifesting in the Russell 2000, Nasdaq, Dow Jones Industrial Average, and the S&P 500. Death crosses happened on: January 19, 2022 for the Russell 2000, February 18, 2022 for the Nasdaq, March 8, 2022 for the Dow Jones, and March 15, 2022 for the S&P 500.
Death crosses are important because they’ve been a reliable predictor of severe bear markets, and we’ve seen them before the Great Depression and Great Recession. So it’s possible it’s happening again now in 2022.
The fact that a death cross first happened in the Russell 2000 could be a significant harbinger of things to come as the RUT is considered a great leading indicator of the overall directionality of the stock market. When there’s declines in the small cap index first, this usually precedes declines in the other major indices.
The reason why is because smaller companies have difficult times absorbing economic shocks and still producing earnings, whereas large cap companies like the ones in the S&P 500 can better absorb these shocks and still produce earnings.
When the Russell 2000 breaks down to a new lower low, that’s signaling that the whole market is getting ready for a bigger decline. The last time we saw this was when a death cross preceded a huge decline in Q4 2018.
Maybe the reason why the Nasdaq has been seeing death crosses is because people might be rotating out of the more speculative growth stocks and trying to seek shelter in more value stocks and the S&P 500. This could be why the S&P 500 is holding up better than the Nasdaq and Russell 2000.
Other reports suggest that a death cross doesn’t necessarily mean that much and might not be very helpful for trying to do market timing because maybe it’s signalling that a market bottom has come in and now stocks can keep going up from here. It could really go either way — up or down.
Even though death crosses are an interesting technical indicator, you shouldn’t base your investing moves based on this indicator alone.
What is an inverted yield curve?
An inverted yield curve pertains to US treasury bonds where if the short term interest rates are higher than the long term interest rates, that’s an inverted yield curve.
It’s a big deal because it’s been one of the best indicators for an upcoming recession in the US.
Since World War II, a recession has happened every time there has been inverted yield curve, about 6-18 months after the inversion happens. The last time we saw this happen was in 2019 before the 2020 recession happened. An inverted yield curve could happen again in 2022.
When an economy is expanding, yields between the longer dated treasury bonds and the shorter term treasury bonds spread wider and there’s a steeper curve. But when the economy is contracting, the spread declines and the curve begins to flatten until it inverts.
If we compare the 2 year and 10 year treasury bond yields from March 1, 2022 to March 18, 2022, we have seen the spread narrowing rapidly and this is causing the yield curve to flatten.
We saw this happen in 2007 when the spread narrowed between the 2 year and 10 year treasury bonds, this indicated that an inversion was imminent and then we had the Great Recession from 2007-2009. The yield on the 10 year bond went below the yield on the 2 year bond, which normally doesn’t happen because if you loan money for longer you expect higher rates of return.
And naturally when a recession occurs, that tends to be correlated with declines in the stock market.
People like tracking US treasury yields because it’s a barometer for US economic progress. It reflects investor sentiment and their collective wisdom about expectations of future economic performance.
Per a Financial Times article, shorter term yields tend to reflect where investors believe short term monetary policy will be in the near term. And longer term yields represent investors’ best guess as to where interest rates, growth, and inflation will be in the medium to long term.
As an economy is slowing down, then expectations for inflation also decline. As that’s happening, the yields on longer term dated bonds like the 10 year and 30 year bonds start falling closer to the short term bonds. That’s when an inverted yield curve happens. And that’s the point when investors believe that The Fed will have less of a need to raise borrowing costs in the future. Hence the yield curve flattens and potentially inverts.
Some have criticized US bond yield curves for potentially being a self-fulfilling prophecy and bringing on a downturn as the yields start to flatten. It’s sort of confusing but I hope this explanation makes sense!
Another way to think about this, is if investors believe an economy is weakening, and they believe The Fed will have to lower interest rates to stimulate the economy again, that usually affects shorter term interest rates.
So investors might want to lock in a higher interest rate on longer term bonds of 10-30 year bonds, and that causes the yields to go down as prices go up as more investors pile in on longer dated bonds.
So as yields on longer dated bonds go lower, that’s when they start potentially going below shorter term yields. Hence an inversion takes place, and then a recession could be a self-fulfilling prophecy as inverted yields start undermining confidence in the economy.
And even if markets get spooked by death crosses and inverted yields, the best investors like Warren Buffett and Charlie Munger are not phased by some of these macroeconomic factors. They continue to study and invest in businesses regardless of what’s happening at the macroeconomic level or what The Fed might be up to.
The reason for this is because interest rates and inflation are out of investors’ control, so the best that we can do is to continue to look for undervalued investments compared to what we’re willing to pay for them.
While these indicators are fun to study, they don’t necessarily impact whether there is a stock buying opportunity or not. Sometimes stocks are still on sale, regardless of whether the economy is in a recession or not.
I like keeping tabs on these macroeconomic factors because if I know a recession is on the horizon, then maybe stocks of my favorite companies might go on sale that I can then buy. But lets not dwell on these indicators too much because it’s probably not such a big deal in the grand scheme of things. 😉
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