Thankfully, three Federal Reserve rate cuts and an improved economic outlook have helped lead the yield curve back to positive territory. The 3-month and 10-year yield spread reached a 10-month high of near 0.4% last week before pulling back some, while the 2-year and 10-year yield spread hovered around 0.25% most of last week.
Still, the yield curve is historically flat, and prior to past recessions, parts of it flickered between positive and inverted territory several times. Because of this, we’re not ready to give the all-clear signal for the yield curve. We’d like to see more sustained steepening, led by a rise in long-term yields.
ISM Manufacturing Index
Recent weakness is U.S. manufacturing activity is concerning despite the manufacturing sector’s relatively small role in the overall economy (manufacturing is about 12% of gross domestic product). Manufacturing is a bellwether for profits and the economy, and bouts of weakness matter for corporate profits, capital investment, and corporate America’s productivity.
Historically, a peak in the Institute for Supply Management’s (ISM) manufacturing purchasing managers’ index (PMI) typically has been followed by a recession about three years later. The U.S. manufacturing PMI hit a new cycle high in August 2018 and has been gradually falling since then. In August 2019, the manufacturing PMI fell below its key 50 level and has remained in contractionary territory (below 50) since then: The latest reading was modestly contractionary at 48.3. The yield curve re-steepening suggests this may just be a shallow downturn, and consumer spending remains quite healthy, but corporate profit growth has stalled and trade remains a risk.
Valuations
It’s logical to think stocks may be expensive after a 360% gain in the S&P 500 Index 10 years into the longest bull market ever. While stocks are certainly more expensive relative to earnings than they were when this bull market began, we consider stocks fairly valued in this environment, especially considering low levels of interest rates and modest inflation.
Breadth
Market breadth measures how many stocks are participating in gains or losses of broader indexes. One of the easiest ways to measure this is via advance/decline (A/D) lines. An A/D line is a ratio of how many stocks go up versus down each day. If gains have been caused by increases in many stocks, then there were plenty of buyers and the upward trend may continue, if everything else is equal. On the other hand, if an upward move in an index was driven by relatively few stocks, it can be a warning sign of cracks in the bull’s armor.
We like to look at the price of the NYSE Composite Index along with the NYSE Common Stock Only A/D line to identify negative divergences from the A/D line. Not only did the A/D line hit a new all-time high in October, but the A/D line has been leading prices higher, suggesting more and more stocks are participating in the market’s advance, evidence of a healthy bull market.