The recent rebound in the stock market has been a welcome relief, but tread carefully. We’re not out of the woods yet.

We could be witnessing a “bear trap.” That’s a common occurrence whereby stocks that have been sharply falling seem to be reversing their fall, but are only pausing before they resume heading south. It happens when excessively optimistic investors misinterpret or ignore bearish indicators.

The Dow Jones Industrial Average on August 5 experienced its worst day of 2019, dropping by 800 points amid worries about the inverted yield curve and how it could presage a recession. Further sell-offs ensued. However, investors in recent days have calmed down as they focus on the positives, such as resilient retail sales and low unemployment.

Stocks have largely recouped their losses from this month’s sell-offs. That said, the rebound is tentative and could stall. As of this writing on Tuesday morning, the three major U.S. stock indices were trading in the red. Volatility is here to stay.

One pillar of the bull market has been TINA (There Is No Alternative). But bullish sentiment may darken, as key economic numbers are released and the tariff fight drags on. Consumer spending and jobs are strong now, but they’re lagging indicators.

This week, pay particular attention to weekly jobless claims, the Markit Manufacturing Purchasing Managers’ Index (PMI), the Markit Services PMI, and leading economic indicators, all due on Thursday. Unexpectedly poor numbers from any one of these data points could easily tank the skittish stock market.

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With Europe hamstrung by Britain’s vote to leave the European Union (aka Brexit) and China’s growth slowing, the U.S. has (against all expectations) adopted the mantle of global growth engine. The bulls point to recent strong data on U.S. employment and retails sales as positives that outweigh such worrisome signals as the inverted yield curve.

Investors also were cheered by an ostensible truce in the trade war, when the Trump administration on Monday gave Huawei Technologies a 90-day reprieve from a ban on conducting business with U.S. companies.

The White House accuses Huawei of illicitly procuring proprietary Western technology, at the behest of Beijing. But the U.S. Commerce Department yesterday delayed for a second time strict rules banning U.S. companies from selling technology components and services to the Chinese telecommunications giant and a prohibition on buying equipment from it.

I contend that optimism about the U.S.-China trade war is misplaced. Even if you think President Trump will eventually announce some sort of grand deal, the damage from existing tariffs is being done every day. Tariffs raise costs for businesses and consumers.

Uncertainty about what comes next also is taking its toll. One of the most troubling aspects of this trade war is its utter lack of coherent strategy.

Some investors are comfortable making investment decisions based on impulsive tweets from government officials. I am not.

Mixed mood on Wall Street…

The market’s mixed mood of optimism tempered by fear could break either way in the coming days. It also seems to me that investors are putting inordinate hopes on further monetary easing this year. Federal Reserve officials are divided over the wisdom of another cut; some are publicly throwing cold water on the idea.

Boston Federal Reserve Bank President Eric Rosengren asserted Monday that U.S. economic conditions are healthy enough and that cutting interest rates again could generate destabilizing debt levels. What’s more, he noted, further cuts would tie the Fed’s hands when the next recession hits.

The inverted yield curve has done much to stoke investor anxiety about a recession. The following chart examines the yield curve’s history as a recession predictor:

A recession could trigger a debt crisis. Low-grade corporate debt is a ticking time bomb, a huge risk that gets almost no coverage by the financial media. (Television networks get better ratings from puff pieces about CEO celebrities.)

During the era of ultra-low interest rates that followed the Great Recession, corporations loaded up on debt. But instead of using that money to invest in organic growth, most of these borrowers launched share buyback programs or funded mergers.

This myopic decision-making was repeated in the wake of the 2017 tax cuts, when corporations used their windfalls mostly to buy back stock and not for internal investments or to pare down debt. This profligacy will come back to haunt the U.S. economy.

In addition to low interest rates, companies have enjoyed other incentives to borrow. Interest costs are tax-deductible, so in essence, the U.S. government has been subsidizing corporate America’s debt spree.

The stigma of lower-grade debt has diminished over the past 10 years, echoing the go-go 1980s when Gordon Gekko-type corporate raiders used junk bonds to finance leveraged buyouts. The crash of 1987 ensued.

Because of the Federal Reserve’s quantitative easing since the 2008-2009 financial crisis, government bonds have sported low yields, prompting investors to seek higher yields via ever-riskier bonds. Companies have exploited this demand.

The confluence of these trends has resulted in a preponderance of BBB rated debt. There’s currently $3 trillion in outstanding U.S. debt rated triple-B, up from $1.3 trillion five years ago and $686 billion a decade ago. That’s the most ever for companies rated triple-B.

Triple-B debt securities are the last rung on the ladder; they’re the lowest-quality debt that qualifies for investment-grade status. A downgrade to double-B pushes a company’s bonds into the high-yield junk territory.

It’s during the latter stage of an economic cycle that this sort of debt starts to become a problem. In a recession, many of these highly leveraged firms could fall victim to a wave of downgrades and defaults.

Another global financial contagion is possible. Indeed, government policy nowadays almost guarantees it.

Since the 2008 global crisis, when big banks sought federal government bail outs, the Federal Reserve has been steadily chipping away at the capital requirements that were put in place to prevent a repeat. Bankers say these rules are burdensome red tape. There’s another reason bankers hate stricter capital requirements: they compel banks to limit stock buybacks and dividend payments.

In the autumn of 2008, terrified bankers went to Uncle Sam with their hats in their hands. They’ve forgotten this inconvenient truth. Unfortunately, so have many investors (and taxpayers).

However, in the next downturn, looser capital requirements could leave the economy more exposed to another meltdown. Meanwhile, with interest rates already low, the Fed won’t have many tools at its disposal. As Mark Twain said: “History doesn’t repeat itself, but it often rhymes.”

Beware the bouncing cat…

President Trump is keen to avoid the reality (or even the perception) that a recession will occur before the 2020 election. Over the last few days, Trump and his economic team have been talking up the economy and blaming the media for conspiring against Trump by trying to spread pessimism.

The folks in Washington can scapegoat the media all they like, but the increasing accumulation of negative indicators is not “fake news.” Unlike politicians, the hard numbers don’t lie.

For example the Federal Reserve reported last week that manufacturing production shrank 0.4% in July, a steeper decline than the 0.1% drop expected by the analyst consensus.

Overall industrial output was down 0.2% last month, after analysts had expected a 0.1% gain. Since December 2018, manufacturing output is down over 1.5%. Trade sanctions and a cooling global economy are taking their bite.

During earnings calls this season, an increasing number of bellwether manufacturing and industrial companies have warned that tariffs are dampening demand and raising costs, putting pressure on margins.

Call it a bear trap, a sucker’s rally, a dead cat bounce — whatever you like. The fact is, the recent recovery in stocks could be the prelude to a correction.

The latest good news (e.g., the supposed truce in the trade war) probably won’t stay good for long. To quote the infamous expression coined by former Fed Chief Alan Greenspan, investors are showing “irrational exuberance.” You can’t afford to fall into that trap.

There’s still money to be made in this market and the team at Investing Daily will show you how. But stick to the fundamentals and above all stay rational.

Questions or comments? I’m here to help: mailbag@investingdaily.com.

John Persinos is the managing editor of Investing Daily.