2 worrisome spreads signaling recession?

I tend to find myself, in this “Internet Age,” wandering off on tangents when I have the luxury to read. I’ll start with one article and then think about a connection, then another and another until I’m so far afield I can’t remember where I started.

But these journeys into the electronic woods of information are also very helpful because they help clear my mind of directly looking for something, retrieving it and moving on. I can see relationships better and get a deeper understanding of the forest as well as the trees.

So, on two recent adventures into the e-woods, I stumbled across two very interesting spreads that don’t look very good for the U.S. economy or stocks in coming months.

Dow’s Rule No. 4

The first I discovered after a conversation with a colleague about Dow Theory.

I’ve written about Dow Theory before, so I’ll just give you a quick backgrounder. Charles Dow, the founder of The Wall Street Journal and developer of the Dow Jones Industrial Average wrote more than 200 editorials in his time at WSJ. Upon his death in 1902, a few of his colleagues pored over his writings and came up with six trading rules from his writings.

This was the beginning of Dow Theory as well as the foundation of today’s technical analysis.

Rule No. 4 is “Stock market averages must confirm each other.” The classic example is, industrials and transports should work hand in hand in a good economy.

That means, if the economy is doing well, companies are making more goods to sell to consumers and the transports (land, sea, air, rail) should be busy shipping all those goods to market.

And the same goes for the downside. If the economy is weakening, demand slows, so production slows and transports slow. Either way, both are moving in sync with one another.

But, if you look at the chart, this is what it the two averages look like today:

Google Finance chart

Source: Google Finance

There are some serious divergences.

The graph tells us that industrials have been relatively flat, but transports have been much stronger.

Generally, this is a dangerous signal. Now, maybe the transports continue to outperform because of the demise of big box department stores and the increase in deliveries of goods directly to consumers. Maybe the growth in the U.S. energy sector means rail traffic has grown and there’s no corollary on the consumer side.

I’m just saying, this is a disturbing trend that has just cropped up in the past few years and for the past century, these divergences haven’t ended well.

Ready for recession?

The second spread is not a widening worry, it’s a narrowing worry.

The 10-year U.S. Treasury yield is falling and the Fed Funds Rate (the short-term borrowing rate big banks get to borrow from the Federal Reserve) is rising.

When the Fed raises rates, usually interest rates rise which increases demand for the higher yields and strengthens the demand for a country’s currency.

However, in this case demand for 10-year Treasuries is increasing, so the yields are staying low. In the meantime, the Fed has promised to continue raising rates.

This sets up a situation that generally results in a recession.

You see, banks use the 10-year as their baseline for setting mortgage rates. They borrow from the Fed and lend to customers and the spread between the two is their profit margin. If that margin is shrinking, banks lend less and the economy begins to look a lot like 2010.

Got hedges?

Now, neither of these two scenarios are set in stone, but they are a significant concern. They are two measures of the fundamental U.S. economy, unadulterated by accountants and financial sleight of hand, and they’re both flashing a fulsome yellow, if not a dim red.

I think there are some sectors of the economy that can withstand the potential fallout from the worst of these scenarios. But the danger is, if a market selloff begins, there’s going to be significant momentum on the downside and it will get very messy before the conflagration is over.

You have to have some hedges in place here. Keep your growth stocks a bit longer in the hopes that things may improve. But also hold rock solid stocks in sectors that will offset the dangers.

And of course, assets like gold, silver and bitcoin will also be smart additions to your portfolio.

Avoid the big banks and insurers since they hold much of their cash in stocks and bonds.

Look to consumer staples like Clorox, utilities like Dominion Resources, midstream energy companies like Oneok, natural gas companies like Golar LNG Partners and deep discounters like Dollar General.

— GS Early

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