Canaries will drop dead faster than humans from toxic gases.

That’s why coal miners used them until the late 1980s. But when it comes to the markets… traders have their own version of the canary.

And last January, this canary sent a warning… telling us it was time to exit the stock market.

By February 20, 2020, those who didn’t heed the warning sign suffered a massive selloff… One that wiped 34% off the S&P 500 in just over a month.

The signs were there… You just needed to know where to look.

Today, I want to show you one of the canaries we watch to gauge when there’s trouble ahead in the stock market.

An Early Warning Sign for the S&P 500’s Collapse

First, if you don’t know the backstory… In the early 20th century, coal miners discovered that canary birds could be used as an early warning signal for the presence of toxic gases.

The canary’s faster heartbeat, small size, and high metabolism meant they would react far more quickly to dangerous carbon monoxide fumes than the miners.

When the canary got sick, or died even, that was the miners’ cue to evacuate the mine.

When it comes to detecting imminent disaster in the financial markets, I like to turn to bonds. This is a little-known trick, but the behavior of bond markets can lead the price action in stocks.

To see what I mean, first take a look at this chart of the U.S. 10-year bond yield. I’ve zoomed in just before the stock market sell-off that began in February of last year…

This chart began tracing out a rising wedge, one of our favorite chart patterns, all the way back in September 2019.

The yields broke out of that rising wedge pattern on January 24, 2020… crashing well before the stock market topped out on February 20, 2020.

Keep in mind that bond yields move inversely to bond prices. So when yields plunged last January, it told us demand for the safe haven of bonds was rising… a sign that investors were fleeing the stock market.

If you were following us then, you may remember that’s when Andy warned traders to be cautious of stocks, as COVID-19 spread around the world. Here’s what he wrote on January 27, 2020:

The strategy of buying stocks on every dip must be avoided for the time being… Greed tends to take some time to develop and mature into bubbles, but fear tends to be far more immediate, leading to flash crashes.

Given the sharp and relentless stock market rally since October of 2019, the magnitude of a down move could be quite fierce… At a minimum, I recommend that you move to a cautious stance, reducing some risk until we see how the coronavirus scenario plays out.

I hope you heeded those warnings.

Because as the chart of the S&P 500 below shows, while bond yields were telling us there was danger ahead, the stock market was in the late stages of its melt up… A true canary in the coal mine.

But the 10-year yield didn’t just warn us about the S&P 500’s collapse… It also gave us a clue as to when the stock market was going to find a bottom.

As you can see in the charts above, the 10-year yield bottomed on March 9, 2020, again well before the stock market found a bottom on March 23, 2020.

What Bonds Are Telling Us Today

Today, the story with bond yields is quite different. The 10-year yield has risen dramatically, from 0.53% to a high today of 1.2% this morning!

This has indeed been bullish for equity markets, as investors have been selling bonds at a furious pace and piling into stocks amid hopes that the economy is going to boom on the back of fiscal stimulus.

The fears that the yield has gone too far, too fast are just starting to circulate amongst analysts and the media.

They are afraid that inflation is returning to the market more quickly than expected… And that if the Federal Reserve raises rates to keep pace, it will bring this market melt-up to a screeching halt.

As usual, however, the media is missing the real story.

The real danger ahead with bonds is not just a rise in rates, which are still incredibly low… But with the historically dangerous durations for bonds.

Duration is not often talked about, but it is incredibly important to understand. Duration does not refer to a bond’s maturity date, but rather to its price sensitivity relative to a move in the interest rate.

In short, duration measures how long it will take, in years, for the holder of a bond to be repaid the price they paid for the bond by the bond’s total cash flows. The higher the duration, the greater the risk to a bond’s price if interest rates continue to rise.

This leaves the Fed, and the market, in a tricky spot. While the Fed may be committing to keep interest rates low, the bond market clearly disagrees. Otherwise, they wouldn’t have more than doubled the 10-year yield over a 180-day period.

This means that if rates continue to rise, the duration risk will become so great it can threaten to implode the entire system, as the price of bonds could be pushed significantly lower.

With $18 trillion of negative-yielding debt worldwide – the highest level ever recorded – the threat of a “debt bomb” is very real indeed.

Also, the fact that yields were so low made stocks relatively more attractive. That’s because there was insufficient yield in the bonds to attract investment flows from investors. 

It won’t require much higher rates before investors start to reallocate funds from stocks into bonds in order to earn the higher interest rates. 

Plus, stocks are typically priced using the discounted present value of future expected earnings, given a certain interest rate. If rates go up, then the present value of the stocks goes down. Earnings would have to really shoot higher for stock valuations to hold up if rates rise any further.

In short, I’m quite sure we have a lot more market volatility ahead of us. I recommend you pay close attention to bonds… and heed any warning signals they might provide.

Regards,

Imre Gams
Editor, Money Trends


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