Fear seems to have taken hold of the stock market right now.

In the past few weeks, volatility has picked up. Applying technical analysis to the broader stock market, the tenor of trading has shifted. This can be seen in the chart below, which shows the S&P 500 index and its 200-day moving average (MA).

The 200-day MA can be used to define the direction of the long-term trend. Notice that the index collapsed in the recent selloff and is now testing the MA. A decisive break below that MA indicates a downtrend in the market, which in this case would most likely lead to a bear market.

The reason I believe a breakdown in the S&P 500 will lead to a bear market is because small-cap stocks have already broken down. Small caps are the most speculative group of stocks in the market because they generally have the weakest financial statements and are the most vulnerable in an economic downturn.

The next chart shows the Russell 2000 Index, a proxy for small caps. In the bottom segment of the chart, you’ll see a sell signal based on monthly data shown by an award-winning indicator I developed and share regularly with my Income Trader readers.

This is a long-term signal, and it shows that stocks are vulnerable to a steep selloff. That is especially true, since a recession is likely next year.

The Case For A Recession Next Year
My opinion that a recession is likely is based on research from Well Fargo Economics Group. This team of researchers has been doing some of the most innovative work related to markets that I’ve seen. An example is their framework for predicting recessions.

Many economists look at an inverted yield curve as a recession indicator. The yield curve is the difference between long-term and short-term rates. Under normal economic conditions, long-term rates should be higher than short-term rates because the risks of inflation are higher in the long run.

#-ad_banner-#Before a recession, the yield curve typically inverts, which means that short-term rates move higher than long-term rates. Before a recession, the demand for long-term loans falls as investors see few opportunities when the economy is weakening. This pushes long-term rates down and results in an inversion of the yield curve.

The inverted yield curve has a great record of forecasting recessions. Since 1955, the San Francisco Federal Reserve has identified nine recessions and an inverted yield curve preceded all of them. There was just one signal that didn’t work, and the economy kept growing after the yield curve inverted in the mid-1960s.

On average, the yield curve inverts about 18 months before the recession.

That’s useful for investors because the stock market usually enters a bear market during a recession. But there have been bear markets without inverted yield curves. That’s where Wells Fargo’s research has an edge.

Their model compares the 10-year Treasury to the fed funds rate. They identify the lowest low of the 10-year when rates were falling. When the Fed Funds rate crosses above that level, the recession indicator is triggered.

This model also predicted all nine recessions since 1955, with an average lead time of 17 months. This model had four signals that didn’t work. That might sound worse than the inverted yield curve model, but the stock market sold off after each of the failed signals.

So, this model has always been followed by a bear market. As an investor, I think this is more important than forecasting recessions.

When interest rates were falling, the 10-year Treasury bottomed at 1.36% in July 2016. The Federal Reserve raised the fed fund rate above that level in December 2017.

That triggered the recession signal, and the recession is expected around May 2019. The stock market should peak before then, and that tells me this recent decline could be the beginning of a bear market rather than a typical pullback.

On average, the S&P 500 falls 11% within a year of the signal. The price target for the index based on this model is 2,380 — more than 10% below current prices as I write this. That’s the minimum target, and the decline could be steeper.

The bottom line of my analysis is that a recession is likely in 2019, and I believe a bear market is also likely before then. That’s why I have been more conservative than average in the past few months, and I will continue exercising caution until market conditions reverse.

P.S. Because risks are high, I want to be more conservative than usual in the trade recommendations I make for my Income Trader readers. Thankfully, I have a proven system in place that has delivered winning income trades through all types of markets — with a 90%-plus accuracy rate.

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