A Volatile Future

Sept 14

3 minutes

Conrad Krol | Andrew Cun | Alexander Cao | Ryan Lung

Bellevue High School

Westbank Financials

Author’s Note

The information contained in this research paper is for educational and informational purposes only and should not be considered as financial advice. Analyses and opinions expressed in paper are based on data available at the time of writing and are subject to change without notice.

In this volatile economy, it is crucial to stay vigilant of economic warning signs that may suggest we are heading towards turbulent times. This article will cover the current state of the US economy and financial markets, highlighting several key indicators that suggest potential challenges ahead.

Exhibit 1: 10 Year – 3 Month Yield Spread

In a normal, upward-sloping yield curve, longer-term bonds usually have higher yields to reward investors for taking on the increased risk and uncertainty of the future. However, recent market changes have caused long-term bond yields to drop, suggesting a more pessimistic view towards the future of the US economy. Historically, the inversion of the yield curve has been a reliable recession indicator. An anonymous ex-Blackrock portfolio manager noted that while the 10-year, 3-month spread is often debated,  “There’s less explanatory power than some suggest”, it tends to have more noise than the 10-2 spread. He believes that the inversion leading to a recession is a mix of both correlation and causation.

Exhibit 2: Federal Funds Effective Rate

The Federal Funds Effective Rate, or Fed Funds, historically shows that when the Fed pivots, the “real” recession begins (marked in gray). The current rate hike is one of the fastest in history, and no one knows when the lag will hit the stock market. Despite the rapid rate hikes, the S&P continues to climb, seemingly defying common sense. Notably, 35% of the S&P 500 is concentrated in the “magnificent 7,” the highest concentration seen since the early 2000s. This concentration was deemed dangerous by our ex-Blackrock source, as these seven stocks accounted for 85% of the 2023–2024 S&P 500 gains, which is disproportionate. Additionally, the P/E ratios of mega-cap stocks have exceeded the healthy range of 25-30, indicating an overbought market that is due for correction.

Sahm Rule

Named after Fed economist Claudia Sahm, this rule specifies that a recession is likely if the unemployment rate (3-month average) rises by 0.5% from its low. Recently, Bloomberg reported that the Sahm Rule has been triggered. As of August 2, the three-month average unemployment rate is 4.1%, which is 50 basis points higher than the 12-month low. The Sahm Rule has been triggered in every US recession since 1970, with only two false positives that were shown to be premature by just a few months. 

This graph shows the recent divergence between the S&P’s price and its index-adjusted price, which accounts for factors like dividends, stock splits, and other adjustments. This divergence could indicate underlying issues or corrections that investors should be aware of. It suggests that while the market may appear stable or even growing, adjusted prices reveal a more pessimistic outlook.

Exhibit 3: S&P 500 Equal Weight EPS Estimates 

In summary, the economic indicators are painting a picture of an uncertain and potentially volatile future. Although most economic indicators are implying a bullish outlook on the future, it would be prudent for investors to remain underleveraged and uninvested as potential downturns despite the economic indicators are likely.