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Volatility reached a five-year high in December, and a downturn could be on the horizon according to the indicators we’re watching.
In fact, one indicator that predicted the last two recessions and market crashes is very close to reaching the danger zone. But it’s not time to panic. We’ll show you exactly what’s going on and what you need to do to stay profitable as the market keeps swinging higher and lower…
If you think the market over the past few weeks has been different than it was during the “good old days” of 2017, you are right. Check out this chart of the average true range in the S&P 500. The change is unmistakable.
The true range of the market is the difference between the daily high and daily low, but it takes into account any market jumps from the previous day’s close. In other words, it puts the day’s gyrations in context.
This chart smooths that out with a 10-day average, and you can clearly see that December-January volatility was far greater than it was a year ago. Look how blissfully low it was in 2017!
Nobody knows for sure why volatility is up, but there are plenty of reasons why investors are nervous. The trade war is definitely one of the top reasons, and we can see big moves higher and lower on any given day based on the progress made between the United States and China.
While trade is, of course, very important, the domestic economy itself is also key.
And one indicator used to forecast recessions is adding to investors’ unease.
In the past, when it fires a signal, a recession follows.
If the economy falls into recession, a market crash could be next…
The Best Recession Indicator to Watch
The recession indicator to be paying attention to right now is the yield curve.
As it steepens, the experts follow it even more closely. The yield curve is simply a plot of interest rates across the U.S. Treasury market by maturity from three months out to 30 years.
When the economy is healthy, the plot of the yields for each security forms a line curving up. But when the line inverts or begins to curve down, trouble is ahead.
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Typically, when the yield curve inverts, meaning long-term interest rates drop below short-term interest rates, the economy struggles. And two of the biggest market crashes over the last 20 years occurred after inversions.
Just to see how close we are to an inversion, we’re looking at the chart showing the difference between yields in the 10-year and two-year Treasury. When the difference falls below zero, then the curve has inverted.
As you can see from the chart, a recession followed the last two reversions.
And we are quickly approaching another one…
The reason an inverted yield curve is such a powerful predictor is because it shows the economy is weakening and there is no demand for businesses to invest in major projects. These projects are funded by long-term bonds. And since interest rates are the price for borrowing money, the lack of demand for borrowing means the price – interest rates – goes down.
Couple that with a Federal Reserve bent on raising short-term rates, and an inversion is almost an inevitability.
But now isn’t the time to panic. It’s time to use the knowledge to profit…
How to Make Money While Volatility Is Rising
The best thing investors can do right now is play their cards a little closer to the vest. Smaller position sizes, less aggressive trades, and strict money management are key to navigating these troubled waters.
Money Morning Technical Trading Specialist D.R. Barton, Jr., offers another way. Profitable traders and investors must be nimble right now, playing any good news on trade against slowing global growth and Brexit fears.
A new trade agreement could stave off a yield curve inversion and send stocks surging higher. Traders need to be ready to pounce on such good news.
But more tariffs, a negative earnings season, or disruptions abroad could push the economy over the cliff.
That means taking profits on declines with short selling and puts, and profits on wild swings higher with quick long positions and calls.
Basically, go with the flow, but don’t overstay your welcome. That does not mean you become a day trader, but rather pay attention to when you have to change gears and reverse your positions.
Remember, there is no honor in standing your ground in the markets.
The good news is that an inverted yield curve does not throw the economy into recession right away. While it did forecast a recession in 2007, 2000, and 1990, the relationship was fuzzy in the 1970s.
And the curve was not inverted at the 1987 top. When you factor that in, you realize it’s not foolproof. It’s a useful indicator, but don’t get burned by overreacting.
When it did lead to recession, it led by as much as two years.
Volatility is likely to stay for a while until some good news on the trade war front or elsewhere sends stocks rallying again.
Be nimble and be open to playing both sides. When the market really tips its hand, you should be ready to dive in on one side or the other, depending on the market’s narrative.
You can look to us here at Money Morning to help you figure that part out…
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