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The stock market's 'secret medication for longevity' has vanished — and that leaves it highly vulnerable to a meltdown

trader red screen

  • For the duration of the nine-year bull market, US stocks have been aided by a so-called secret medication that has helped them recover.
  • The Leuthold Group argues this backstop has disappeared, leaving the market particularly vulnerable to weakness.

When stocks get whacked, so do bond yields. Or at least they're supposed to.

That has been the case for eight of the past nine 10% stock corrections, which have been accompanied by bond-yield declines of 50 to 150 basis points, according to data compiled by The Leuthold Group.

It's the one outlier — which just so happens to be the most recent instance — that has the firm worried. Since the stock market peaked on January 28, 10-year Treasury yields have actually increased by 10 basis points, Leuthold points out. That's despite the sharp correction that rocked all major indexes in the interim, reaching its darkest depths in early February.

4 19 18 yields vs stocks COTD

Leuthold sees this as a highly alarming development. It says the corresponding drop in bond yields has actually been instrumental in aiding past correction recoveries.

"To some extent, these corrections proved self-medication," Doug Ramsey, Leuthold's chief investment officer, wrote in a client note. "Falling stock prices forced yields to decline, providing another dose of stimulus to the economy while at the same time reducing an already-low hurdle rate for investors."

The relationship between stocks and bonds that has so piqued Leuthold's interest is a crucial yet overlooked one. And the firm's findings so far in 2018 have been prescient.

In a report from early February — right before US stocks hit their year-to-date low — the firm warned that the speed of credit deterioration had flashed a sell signal. Given how accurate that ended up being, investors would be wise to heed its warning.

But that's not to say the nine-year equity bull market is headed for an imminent demise. There are still plenty of catalysts underpinning further strength, most notably continued corporate profit growth, and recent headwinds have been minimized.

What Leuthold is saying is that the market's ability to recover from a meltdown is severely hampered without the baked-in backstop of lower bond yields. Whether it actually does fall off a cliff is another story entirely.

"We're not arguing the market can't bottom without the drug of lower yields — and indeed the slack in the economy that allowed yields to drop no longer exists," Ramsey said. "Just beware that the bull's secret medication for longevity is not currently available. And a bull that's 'off its meds' sometimes exhibits not only change in character, but a change in species as well."

SEE ALSO: Forget a trade war — there's a more threatening 'bogeyman' that should have traders very scared

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