Carol works downstairs. She asked: "What's up with this crazy market I see on the news? My nephew is good trading stocks. He even said it's nuts!"

I said: "Everyone's freaked out about inverted yield curves – a flag for recession. But the news needs to make money and wants your eyeballs. The quickest for that, is through fear."

"I guess," Carol said, "but stocks are moving so much!"

"Carol, here's a question: did you sell stocks this week?" I asked.

"No."

"How about your nephew?"

"No, I don’t think so..."

"I didn't sell anything! I bet if we go ask everyone we see if they sold, their answer would be: no."

"Then who is it?" she asked.

"AHA! It's machines."

According to this article, 80% of the market's volume is algorithmic or computerized trading, which thrives in low-liquidity markets.

It's the first week of school here in South Florida, bringing my family usual stresses. But on Wall Street, many are cruising to their summer vacation homes. Desks are staffed by junior traders. With fewer people at work, computers push prices around to capture intraday volatility.

As selling spiked Monday, a $2 billion fund trader asked my research firm a question about what our focus is coming up. I'll summarize:

  1. Our ratio fell, indicating that buying dried up. Another selling week could drop it below 45%. Whenever we see the ratio fall below 45%, we've always seen more selling. But it's usually the eighth inning before the bottom.
  2. Of total signals, 22% were buying, down from 35% the week prior. Buying hasn't returned. Exchange-traded fund (ETF) volumes rose – buying risk-off, selling risk-on. ETF volume typically spikes at the bottoms. 
  3. Volumes were high Monday but lower through the week. I think that selling isn't over. Buying was defensive – in real estate investment trusts (REITs), utilities, and health care.
  4. This week was not capitulation. Normally, that's when 50% of our universe shows sell signals. Think of the end of December – right at the bottom. 
  5. Looking at sectors, energy, financials, materials, industrials, and discretionary felt pain. Only energy is close to oversold. That means we've seen worse selling before.
Table showing unusual institutional (UI) signals by secto
www.mapsignals.com 

Bottom line: I expect more downside. Long-term investors should seek buying opportunities now. Near-term strategies warrant patience for a bigger dip. 

We've warned of August volatility. All through July, we wrote it, and on cue, on Aug. 1, it came in heavy. When liquidity dries up, algorithms need news to act on. On Wednesday, the news hit that the yield curve inverted. Doom and gloom freaks everyone out and sells more ads.

Then, algo-traders take advantage and push prices around. High-frequency, short-term, and day trading … all cause volatility. Bespoke Research says August is one of the worst months for performance and volatility. I have bad news for you: September sucks too, so be prepared.

Chart showing the average monthly percentage change for the Dow Jones Industrial Average
Bespoke (2018)

Listen: don't freak about the inverted yield-curve. Headlines paint the end of the world and a red flag for recession. Global growth is slowing, and it's all downhill. Is it?

First, Germany did slip into a recession, and there is a global growth slowdown, as China's reporting. Latin America is a mess, as evidenced by a one-day 48% plummet last week for Argentina's Miraval Index.

But things in the United States are great. Second quarter earnings just wrapped with fantastic numbers. About 75% of companies beat earnings, and 57% beat sales estimates. Profit margins are increasing. 

Global investors will realize that U.S. stocks are the oasis. There's just a capital flight now out of European stocks. They're nervous about everything: Brexit, global slowdown, and wanting to buy Greenland. It wouldn't surprise me if they're nervous about your kid riding a bike without a helmet. 

They are fleeing to long-dated bonds because they're safer, which squishes yields. If you lend for a long time, you get a premium. If you lend a short time, you get less. That's a normal yield curve (yellow below). But when everybody rushes to buy 30-year bonds, that yield curve squishes down, and the front end might invert a little bit. The normal curve looks like the yellow below, and right now we have the green:

Chart showing the U.S. yield curve
FactSet

A headline read: "First yield curve inversion since 2005 which preceded 2007-2009 recession: Inversions preceded every recession." But it's a way to lie with statistics. While every recession was preceded with a yield curve inversion, not every yield curve inversion has preceded a recession. 

And frankly, this time, it's different. The situation in 2007 was a leveraged debt bomb with speculative home buying assuming never-falling prices. Big banks bundled those mortgages together and sold them as AAA-rated paper to pension funds and endowments. 

What happened? Defaults soared above expectations, and the housing market collapsed. The whole thing went up in flames. But today, we don't have major leveraged debt bombs that anybody's talking about. But people still worry – so much so that most of Europe's yield is negative, meaning investors prefer to pay for safe money than earn returns.

Table showing yield across different maturity buckets in Europe
JPMorgan

Again, U.S. earnings are great, taxes are low, and profits are high. While there are clear international risks, once logic prevails, there will be a rush into U.S. equities: specifically, domestic small-cap names with low international exposure.

As you know, Trump delayed tariffs until December. That rally fizzled, met with negative yield curve news. But facts remain – bond interest is taxed as ordinary income, while dividends are taxed as long-term capital gains. Holding stocks gives you 62% more money!

Table showing the total return advantage of stocks over bonds

This is very bullish – not bearish. Even if a recession comes, market peaks happen 18 to 24 months after that. And how does the market typically do? These are the average returns for the S&P 500 following yield curve inversions since 1978.

Chart showing the average performance of the S&P 500 following a yield curve inversion
Marketwatch

Now is a good time to look for the best stocks with the strongest fundamentals: strong one- and three-year growth, high profits, low debt, moats, and unique business models. These tend to be the big winners.

So don't freak. Relax and enjoy a vacation. That's what Wall Street is doing. 

This is August. But don't forget September. Or October. Mark Twain said: "October: This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February."

The Bottom Line

We (Mapsignals) continue to be bullish on U.S. equities in the long term, and we see any pullback as a buying opportunity. Weak markets can offer sales on stocks if an investor is patient. 

Disclosure: The author holds no positions in any securities mentioned at the time of publication.