In order to decipher the stability of the stock market from an underlying perspective, there are multiple pieces of information that must be considered. First and foremost, are companies growing (increasing sales, increasing profit, hiring more, etc) or are they declining (laying people off, closing stores, rolling back products, etc).
Finding this information is actually pretty easy. Simply google search the company and compare current stats with where they were a year ago and a quarter ago. If each quarter shows more revenue than the quarter before, you know the company is growing and vice-versa.
If a majority of companies within the S&P 500 are growing, the overall stock market will generally rise. However, when they stop growing is when investors get concerned about recessions and bear markets. This is when they look into other aspects of market stability.
The Federal Reserve is the central bank of the United States. The job of the Fed is to stabilize our economy and keep it running as best they can. Many are quick to blame the Fed when things go wrong, but if you remember your lesson on market cycles, some things are beyond their control.
One of the main levers the Fed uses to control monetary policy is interest rates. They evaluate the entire economy from the top down to evaluate where we stand, and what our trajectory looks like. When things are booming, they typically raise interest rates slowly. When things start to look bleak, they cut interest rates to help keep money moving.
The Fed recently cut interest rates by 25 basis points to 2.00-2.25%, signaling a slowing economy. It was the first rate cut since the 2008 financial crisis. Many experts are calling for additional rate cuts before the end of 2019, but nobody knows how much further the rate cuts will go at the moment.
As mentioned earlier, cutting interest rates is a strategy to keep money moving by making it cheaper to borrow money (because interest rates from the federal bank are lower). So, what happens when interest rates can’t be cut anymore? Well, that’s part of the recipe for a recession. If interest rates are at their lows, the Fed has nothing left to cut to help stimulate the economy. This is one marker to keep an eye out for, as it can indicate a recession is, in fact, right around the corner.
Inverted Yield Curve
One of the biggest predictors of a turning point in the market cycle is an inverted yield curve. In short, an inverted yield curve is when short-term interest rates are higher than long-term interest rates. For example, a 2-year Treasury bond returns 2.1% interest, while a 10-year Treasury bond returns 1.8% interest.
The reason this is important is because of investor psychology. If people can earn more money with a shorter term investment than they would with a longer term investment, they’re more likely to take their capital out of the stock market and put it into the bond market. Less money flowing through the stock market causes stock prices to decline (based on the laws of supply and demand).
The yield curve inverted in March of this year, causing more concern in the stock markets amid the myriad of other factors we have already discussed. These rates change by the minute, just as a stock price does, but the yield curve has remained inverted, broadly speaking, and has signaled to investors that the cycle may be turning downwards.