Trading Nation

Here are the three big warning signs for the market from Tom Lee

Key Points
  • Lee is concerned that the long-term yield curve has narrowed substantially.
  • He is watching what he refers to as an "abrupt reversal" in market leadership.
  • He recommends investors stick with "FANG" stocks.
Why Tom Lee is worried about stocks
Why Tom Lee is worried about stocks

Strategist Tom Lee has a clear message for investors: Stocks are carrying more downside risk than upside risk at this juncture.

Lee, founder and head of research at Fundstrat Global Advisors, outlined in a recent note to clients that indeed he remains optimistic on economic growth, though he cautions that the market is sending three clear-cut signals that equities are slated to slide in the near-term.

"I think my biggest concern is that the stock market is betting on an acceleration in growth this year, even at a time when corporations might take a break until they figure out what tax reform looks like, and it's coming at a time when margin debt is so high," Lee said in an interview Monday on CNBC's "Trading Nation."

First, Lee is concerned that the long-term yield curve has narrowed substantially. A flattening yield curve is a widely viewed marker of slowing economic growth, as this suggests the expected return of long-term spending then has smaller expected return on investment. The spread between the 30-year Treasury yields and the 10-year Treasury yields, as Lee observed, has flattened since just after the U.S. election in November "and historically signals market weakness ahead."

"In the past, the bond market has been much better at ferreting out problems and smelling slowdowns; that's the message from the yield curve. So I think the bond market is really taking the position that growth is going to disappoint, and the gap between the hard data and the soft data is still pretty big," Lee said Monday.

Secondly, Lee is watching what he refers to as an "abrupt reversal" in market leadership in the last five months. Lee points to reversals in sectors like financials and energy, now both negative on the year after rallying in the weeks following the election. And leadership in different measurements like long momentum, the S&P 500 Buyback Index and the Dow Jones Contrarian Index have also reversed in the same timeframe.

Next, he outlined the high-yield option-adjusted spread widening. Specifically, Lee notes that since 1998, the market has seen 30 instances in which high-yield spreads widened 60 basis points, as it did in late March, and the market saw a decline in 93 percent of instances (falling by a median 4 percent). The thinking is that high-yield indicates a tightening of financial conditions.

How are investors to position their portfolios with these indicators afoot? Lee recommends investors stick with "FANG" stocks — Facebook, Amazon, Netflix, and Google parent Alphabet — as the names are "least exposed to wage inflation."

Notwithstanding these concerns, the S&P rose more than 1 percent on Tuesday following an outcome seen as positive from the French presidential election.