The S&P 500 crashed Thursday morning. It bottomed at 2,624 at 11:30 AM which was a 2.83% decline. It rallied in the afternoon to close down only 0.15%.

Many of the bulls may feel like that’s a sign of a reversal. But I think it’s a sign the market is still in correction/bear market mode. These volatile swings occur when the market is falling. The biggest up days occur in bear markets.

S&P 500 needs to fall 2.35% to get to its November 23rd low. Nasdaq outperformed the S&P 500 throughout the day as it was up 0.42%. Russell 2000 fell 0.23%. VIX was up 2.15% to 21.19. The CNN fear and greed index fell from 20 to 15 which signals extreme fear.

Trade Uncertainty Grows

Traders are skeptical of the trade deal with China especially since the CFO of Huawei was arrested. In China’s statement some of the details on the 90 day agreement to negotiate without tariffs being raised were different than in America’s statement.

As you can see from the table below, the 90 day deadline wasn’t mentioned by China. America didn’t mention bilateral visits while China did.

China mentioned America respecting the One China policy while America didn’t. This brought a huge level of uncertainty to the potential of a deal. When investors can’t handicap the possibilities, they sell now and ask questions later. Both China and America are seeing economic growth slow.

China’s Composite PMI was up from 50.5 to 51.9 in November, but the overall trend is down. Both sides will benefit from a deal.

Sector Performance

I have been following Rollins stock closely because of its high valuation. The firm is in the slow and steady pest control business, but trades at a 60 PE multiple. Something finally gave out on Thursday as its stock fell 5.65%.

Amazon stock led the market out of its crash as it was up 1.85%. With Apple and Facebook weak, Amazon and Microsoft need to do the heavy lifting to push the market higher.

The best sectors were real estate and communication services as they increased 2.66% and 1.04%. Real estate stocks love low interest rates. So do home builders, as the ITB was up 1.86%.

Financials and energy fell the most as they fell 1.44% and 1.77%. KRE regional bank index fell 0.8%. The yield curve actually steepened. But traders are still worried about the possibility of an inversion and the slowing economy.

Yields Fall & The Curve Steepens

The 10 year yield is now at 2.9% which is a 36 basis point decline from the peak in November. The two year yield is at 2.77% which is a 20 basis point decline from its cycle high. The difference between the 2 yields is 13 basis points which means the curve steepened slightly.

With the two-year yield falling, the Fed’s rate hikes will invert the near maturity portion of the yield curve. Somehow the Fed wants to raise rates to between 3% and 3.25% in 2019.

That would put the two-year yield below the Fed funds rate. Of course, the market would have the two-year yield above 3% if it believed the Fed would hike that much. If the Fed doesn’t change its dot plot at its December 19th meeting, there will be a stock market crash.

Bear market territory would be reached quickly

As you can see from the chart below, the market is now expecting zero rate hikes in 2019 after the rate hike in December. If the Fed stays with three hikes in 2019, it will be way more hawkish than expectations.

Even it lowers expectations to two hikes, it will be very hawkish. On the other hand, it will be tough for the Fed to justify changing its dot plot by more than one hike since the labor market is so strong.

72.3% Chance Of A December Hike

Currently, there is a 72.3% chance of a hike in December. I have wavered on the possibility of the hike in December. Sometimes I think the S&P 500 falling below its November low would stop a hike. Other times I figure the Fed is in too deep to turnaround.

The Fed has been guiding for a hike for months. How could it change its stance just before the meeting? There have been some rumors that the Fed won’t hike, but nothing substantial has changed in the Fed’s rhetoric.

It’s complicated because if the Fed is expected to hike rates, stocks fall. If the Fed is expected to keep rates unchanged, the market rallies which boosts expectations for a hike.

Who knows where the odds will end up based on that scenario? The Fed isn’t afraid to invert the yield curve, but it might be afraid of the stock market volatility.

No Recession In The Cards?

The table below gives the bulls ammo in their battle which has gotten tough since the start of October. As you can see, only two of the recession indicators have been breached and seven are green.

When the 10/2 year differential falls another 13 basis points, it will only be the third of 10 indicators to signal a recession is coming. When it does invert, a recession occurs on average 17 months later. That would mean there will be a recession in mid-2020.

The question now is if stocks should sell off in December 2018 because there could be a recession in 1.5 years. If stocks sell off now, there won’t be a big decline during the recession.

Usually, stocks fall during recessions, not a couple years before them. However, the Nasdaq peaked in March 2000, but the recession started in March 2001.

Conclusion

The stock market was very volatile on Thursday. The market knows the Fed meeting will be pivotal. Bulls are hoping the Fed pauses rate hikes after the one in December. Plus, the Fed could invert the yield curve even if the December hike is the last one of the cycle. It may have overestimated the neutral rate.