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Inside the Market What’s next for markets? These five charts will show you the way

Investors fled equity markets in late 2018 in fear that rising interest rates and inflation pressures would threaten stock valuations and profit margins. This year, markets have recovered strongly after the Federal Reserve and the Bank of Canada, in part as a recognition of market volatility, backed off on their intentions to tighten monetary policy.

The S&P/TSX Composite and S&P 500 have almost recovered all of the lost ground from their respective 2018 peaks with central banks in a cautious, wait-and-see position for the foreseeable future. So what’s next for investors?

With markets seemingly in search of direction, I’m following five charts, shown here, to identify the future direction for stock prices. While the charts may seem U.S.-centric, they are still highly relevant for the Canadian investor: The S&P/TSX Composite has been closely following the S&P 500 recently and global economic data have been affecting both indexes to roughly the same degree.

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Chart 1: If I could only pick one chart to highlight the main drivers of market volatility over the past six months, and where stocks may head in the future, it would be the comparison of the S&P 500 and the Goldman Sachs U.S. Financial Conditions Index.

1. Equity markets have tracked

financial conditions

S&P 500 Index

(left scale)

GS U.S. Financial

Conditions Index

(right scale, inverted)

98

3,200

3,000

99

2,800

2,600

100

2,400

2,200

2,000

101

A

2018

M

J

J

A

S

O

N

D

J

2019

F

M

CARRIE COCKBURN/THE GLOBE AND MAIL,

SOURCES: BLOOMBERG; SCOTT BARLOW

1. Equity markets have tracked financial conditions

S&P 500 Index

(left scale)

GS U.S. Financial Conditions Index

(right scale, inverted)

98

3,200

3,000

99

2,800

2,600

100

2,400

2,200

2,000

101

A

2018

M

J

J

A

S

O

N

D

J

2019

F

M

CARRIE COCKBURN/THE GLOBE AND MAIL,

SOURCES: BLOOMBERG; SCOTT BARLOW

1. Equity markets have tracked financial conditions

S&P 500 Index

(left scale)

GS U.S. Financial Conditions Index

(right scale, inverted)

98

3,200

3,000

99

2,800

2,600

100

2,400

2,200

2,000

101

A

2018

M

J

J

A

S

O

N

D

J

2019

F

M

CARRIE COCKBURN/THE GLOBE AND MAIL, SOURCES: BLOOMBERG; SCOTT BARLOW

Developed by high profile Goldman Sachs economist Jan Hatzius, the financial conditions index uses bond yields, corporate bond spreads, central bank rates and the trade-weighted U.S. dollar to measure the availability of credit for corporations.

From mid-2018, U.S. equities have moved almost exactly in accordance to credit conditions – falling as credit became more expensive, and climbing as corporate borrowing became steadily cheaper in 2019. (Note that the financial conditions index is inverted to better show the trend.) Changes in financial conditions will no doubt continue to have influence over stock prices in the near term.

Chart 2: The yield curve has received a ton of attention both domestically and south of the border as a possible signal of approaching recession. The yield curve’s proven ability to predict the CBOE Volatility Index (VIX), however, is more important for investors than the economic implications, in my opinion.

2. Predicted increase in market volatility

a negative for returns

CBOE Volatility Index (VIX)

(left scale, lagged 36 months)

10-year U.S. Treasury yield minus two-year

Treasury yield (right scale, inverted)

-1%

70

-0.5

60

0

50

0.5

40

1

30

1.5

20

2

10

2.5

3

0

1991

1995

2000

2005

2010

2015

‘18

CARRIE COCKBURN/THE GLOBE AND MAIL,

SOURCES: BLOOMBERG; SCOTT BARLOW

2. Predicted increase in market volatility

a negative for returns

CBOE Volatility Index (VIX)

(left scale, lagged

36 months)

10-year U.S. Treasury yield

minus two-year Treasury yield

(right scale, inverted)

-1%

70

-0.5

60

0

50

0.5

40

1

30

1.5

20

2

10

2.5

3

0

1991

1995

2000

2005

2010

2015

‘18

CARRIE COCKBURN/THE GLOBE AND MAIL,

SOURCES: BLOOMBERG; SCOTT BARLOW

2. Predicted increase in market volatility a negative for returns

CBOE Volatility Index (VIX)

(left scale, lagged 36 months)

10-year U.S. Treasury yield minus two-year

Treasury yield (right scale, inverted)

-1%

70

-0.5

60

0

50

0.5

40

1

30

1.5

20

2

10

2.5

3

0

1991

1995

2000

2005

2010

2015

‘18

CARRIE COCKBURN/THE GLOBE AND MAIL, SOURCES: BLOOMBERG; SCOTT BARLOW

Merrill Lynch quantitative strategist Savita Subramanian uses the yield curve as an indicator of market volatility with a 36-month lag (the current shape of the yield curve will affect the VIX three years from now).

The future course of the VIX (the light blue line) can be expected to track the existing purple line on the chart, which means the relationship currently points to a sustained, multiyear increase in volatility. Rising volatility is usually associated with down markets.

Chart 3: The year-to-date rally in equity markets has been accompanied by a steady reduction in corporate profit forecasts. The coming U.S. earnings season is expected to produce the first year-over-year decline in profits since 2016. A negative result represents a drastic slowdown from previous growth levels, and expectations for the second quarter, while positive, aren’t that much better.

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3. S&P 500 profit growth

Year-over-year percentage change

 

 

 

2017

2018

2019 (estimated)

14.6%

Q1

23.20

-1.50

10

25.80

Q2

1.10

7.20

27.50

Q3

2.60

15.20

14.20

Q4

9.40

CARRIE COCKBURN/THE GLOBE AND MAIL,

SOURCES: BLOOMBERG; SCOTT BARLOW

3. S&P 500 profit growth

Year-over-year percentage change

 

 

 

2017

2018

2019 (estimated)

14.6%

Q1

23.20

-1.50

10

25.80

Q2

1.10

7.20

27.50

Q3

2.60

15.20

14.20

Q4

9.40

CARRIE COCKBURN/THE GLOBE AND MAIL,

SOURCES: BLOOMBERG; SCOTT BARLOW

3. S&P 500 profit growth

Year-over-year percentage change

2017

2018

2019 (estimated)

 

 

 

14.6%

Q1

23.20

-1.50

10

25.80

Q2

1.10

7.20

27.50

Q3

2.60

15.20

14.20

Q4

9.40

CARRIE COCKBURN/THE GLOBE AND MAIL, SOURCES: BLOOMBERG; SCOTT BARLOW

The combination of higher stock prices and lower earnings is an unlikely pairing and also unsustainable. First-quarter earnings results will be even more important to global markets than usual – profits below expectations and further reductions in earnings estimates for 2019 would have very negative effects on stock prices.

Chart 4: The Financial Times’ senior investment commentator Michael Mackenzie is using the U.S. yield curve – specifically the difference between the 30-year Treasury yield and 10-year Treasury yield – to gauge the market’s faith in the outlook for the U.S. economy.

4. U.S. yield curve reflects market faith

in economic reflation

U.S. 30-year bond yield minus

U.S. 10-year bond yield

0.90%

0.80

0.70

0.60

0.50

0.40

0.30

0.20

0.10

0

2014

2015

2016

2017

2018

‘19

CARRIE COCKBURN/THE GLOBE AND MAIL,

SOURCES: BLOOMBERG; SCOTT BARLOW

4. U.S. yield curve reflects market faith

in economic reflation

U.S. 30-year bond yield minus U.S. 10-year bond yield

0.90%

0.80

0.70

0.60

0.50

0.40

0.30

0.20

0.10

0

2014

2015

2016

2017

2018

‘19

CARRIE COCKBURN/THE GLOBE AND MAIL,

SOURCES: BLOOMBERG; SCOTT BARLOW

4. U.S. yield curve reflects market faith in economic reflation

U.S. 30-year bond yield minus U.S. 10-year bond yield

0.90%

0.80

0.70

0.60

0.50

0.40

0.30

0.20

0.10

0

2014

2015

2016

2017

2018

‘19

CARRIE COCKBURN/THE GLOBE AND MAIL, SOURCES: BLOOMBERG; SCOTT BARLOW

When the 30-year yield climbs relative to the 10-year, this causes the line on this chart to slope upward, and implies that global investors believe in continued U.S. growth and that a recession is postponed. U.S. growth is, of course, vital for Canadian exporters. And the domestic economy’s dependence on exports will likely increase as indebted households rein in consumption.

Chart 5: The difference between Canadian and U.S. short-term bond yields has been the most important determinant of the value of the loonie, even more so than crude prices. Two-year yields are a reflection of central bank interest rate policy expectations, so this chart underscores the importance of the Fed and the BoC in deciding the value of the Canadian dollar.

5. Relative bond yields should continue

to drive Canadian dollar

Canadian dollar (left scale, in US$)

Two-year Canadian bond yield minus

two-year U.S. bond yield (right scale, %)

$1.00

0.8%

0.6

0.95

0.4

0.90

0.2

0.85

0

-0.2

0.80

-0.4

0.75

-0.6

0.70

-0.8

0.65

-1

2015

2016

2017

2018

2019

CARRIE COCKBURN/THE GLOBE AND MAIL,

SOURCES: BLOOMBERG; SCOTT BARLOW

5. Relative bond yields should continue

to drive Canadian dollar

Canadian dollar

(left scale, in US$)

Two-year Canadian bond yield

minus two-year U.S. bond yield

(right scale, %)

$1.00

0.8%

0.6

0.95

0.4

0.90

0.2

0.85

0

-0.2

0.80

-0.4

0.75

-0.6

0.70

-0.8

0.65

-1

2015

2016

2017

2018

2019

CARRIE COCKBURN/THE GLOBE AND MAIL,

SOURCES: BLOOMBERG; SCOTT BARLOW

5. Relative bond yields should continue to drive Canadian dollar

Canadian dollar (left scale, in US$)

Two-year Canadian bond yield

minus two-year U.S. bond yield (right scale, %)

$1.00

0.8%

0.6

0.95

0.4

0.90

0.2

0.85

0

-0.2

0.80

-0.4

0.75

-0.6

0.70

-0.8

0.65

-1

2015

2016

2017

2018

2019

CARRIE COCKBURN/THE GLOBE AND MAIL, SOURCES: BLOOMBERG; SCOTT BARLOW

Taken together, the five charts remind us that positive market returns in the next few months are dependent on inflection points – from negative to positive – in either the corporate profit outlook or the global economy. I’m not convinced that market prices currently reflect a year-over-year decline in first-quarter U.S. profits. Investors can expect some intense selling pressure if analyst forecasts are correct.

U.S. economic growth, at least for now, appears resilient. Economists estimate domestic product growth of 2.4 per cent for 2019, which is significantly above the 1.5-per-cent expansion predicted for the Canadian economy. On Wednesday, however, weaker than expected data on U.S. services industry activity “underscored the impression that America’s growth rate is decelerating,” according to CIBC economist Avery Shenfeld.

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It does seem that, with central banks on hold, markets are now at a pivotal point. Either corporate and economic data stabilize and pave the way for another leg up in stock prices, or volatility hits and markets reprice to reflect deteriorating fundamentals. These five charts should help investors determine which way we’re headed.

Scott Barlow, Globe Investor’s in-house market strategist, writes exclusively for our subscribers at Inside the Market.

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If you would like to write a letter to the editor, please forward it to letters@globeandmail.com. Readers can also interact with The Globe on Facebook and Twitter .

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