Trader’s Narrative

According to the simple stock market timing method which relies on the 30 day rate of change of the 10 year treasury bonds, we are very oversold and should expect a rebound here.

This system is somewhat better at finding tops than bottoms, but it is a good general indicator to throw in the pot:

The rate of change (bottom panel) is really off the charts. The chart doesn’t go back that far but we haven’t had a reading this low since May 2003 when the S&P 500 was at 1000; lifting off a triple bottom and escaping from the clutches of the bear market.

Last week I talked about how the breadth numbers for NYSE and Nasdaq can diverge quite a bit. Which means that if you’re watching just one of them, you don’t get the whole picture.

This can be especially problematic when we have the bond market making a strong trending move, which we’ve had recently. On June 7th 2007, just one day after I wrote about this, the NYSE advance decline numbers dipped into an extreme oversold reading of -2784. To show you have extreme this was, we didn’t see this sort of breadth even after the September 11th terrorist attacks.

The last time the NYSE advance decline approached such an extreme in recent history was May 7th 2004, when it hit -2926. So what was special about May 2004? After all, the summer intermediate bottom of 2004 didn’t happen until a few months after in mid August.

Well, as you can guess, May 2004 was another time when bonds were being dumped left, right and center and the yield was shooting higher. Then, the 10 year bond yield breached 4.87% and panicked everyone, just like it is doing now.

So, not surprisingly, all those bond-like securities trading on the NYSE got dumped. And that created the lopsided breadth numbers. Anyway, back to present day.

On June 7th 2007 the NYSE breadth was -2784. But the Nasdaq breadth was only -1725. Fairly low but not extremely so. To put that into perspective, the March 2007 bottom saw a reading of -2579 (for the Nasdaq advance decline).

Anyone watching just the NYSE numbers would have thought that we had arrived at a historically oversold level. And perhaps may have charged ahead and bought “the dip”. But the oversold reading was a mirage created by the changing nature of the securities traded on the NYSE.

I looked back only a few years and it seems that when the Nasdaq and NYSE breadth numbers both reach an extremely low level, it is much more probable that the market has reached a bottom. This is just a “back of the envelope” calculation, so don’t take it as gospel. To me though, it just makes sense. I’m going to take a deeper look and go back a few more years to see if this holds under different market conditions.

To see instances where both the Nasdaq and the NYSE’s advance decline numbers hit extremes, click to enlarge graph:

So everyone is running around in a panic, dumping bonds and equities for fear that the Fed will increase rates to fight inflation. The 10 year bond yield, which everyone is watching like a hawk all of a sudden, has been blasting higher in anticipation.

Only thing is, I can’t seem to find any footprints of this inflation monster everyone is afraid of. But the markets are a forward discounting mechanism. Maybe they are sensing that inflation, although not here right now, is just around the corner.

True, markets do look forward and incorporate all sorts of scenarios but wouldn’t that same forward discounting mechanism be at work in markets like gold, silver, and the CRB (Commodity Research Bureau Index)?

Each of these markets is also a tell for upcoming inflation. And each of those tells is not confirming inflation fears. Gold, which I’ve already covered, is actually in what looks to be a topping pattern after a multi-year bull market.

The same can be said for silver (and perhaps with much more conviction). And last year, the CRB index broke its long term uptrend line. This trendline had been in effect since the double bottom of the CRB (in early 1999 and late 2001 at the 185 area) so it was very significant.

Getting back to the bond market, for the past 20 years, the 10 year bond yield has been in very orderly down trending channel. Everytime it has hit the top of this channel, bonds have rallied. This has happened about half a dozen times. Once again we are at the top of the channel.

Is it different this time?

With the rising yields (falling prices) in the long end of the bond market, the yield curve is back to normal. Short term yields (90 day) are at around 4.80% and long term yields (30 year) pushing 5.25%.

The 10 year bond, what everyone seems to be watching these days, gapped up and closed very strong. This sort of move, although seemingly strong, is usually indicative of the last sprint before exhaustion. Which is why such gaps are called “exhaustion gaps” - but only in hindsight since its 20/20

So while the 10 year bond yields are rising, perhaps saying that the Fed won’t cut… the very short term bond market is staying stubbornly below the Fed funds rate. Only one of them will be proven right.

In any case, all this attention on the bond market got me thinking about simple mechanical trading systems that I mentioned before. I wondered if the bond market could be used to time the stock market in the intermediate term.

Tops are extremely difficult to identify. I haven’t really found many reliable indicators for the job. Put/call ratios and the myriad variations of that sort of data? Helpful. Sentiment surveys? At times. But what about bond yields?

I looked at the 10 year bond yields and did a very simple 30 day rate of change (ROC) calculation and compared it to the S&P 500 index. Surprisingly, it did a very good job of pointing out market tops. Take a look.

Click to Enlarge Graph

As you can see, when the ROC was approaching 9% things got a bit queasy for the bulls. The most recent case being just a few days ago.

The one glaring mistake it made was in October 2005 where it flagged the exact intermediate bottom as a top. But we can easily avoid that sort of thing by having a simple condition that the signal is only good if the market has been rising in the most immediate past.

And eventhough I wasn’t looking for it, the reverse (low ROC) is also a fairly good indicator of market bottoms. But of course, this is just too small a sample to be robust. At best it is a good starting point.

Last Friday I mentioned that everyone was beginning to fret about the sharp rise in the 10 year bond yield (or fall in bond prices).

I’m not totally convinced that this will mean real trouble for the equity market. We could experience some turbulence but the underlying uptrend is still intact. Atleast from the metrics that I’m following. I really doubt whether this one data point will mean the end of the bull market.

It is true. Historically, when the market was at an all time high and the yield on 10-year Treasury Notes rose sharply over a short time, we have seen at best a sideways to slightly down market going forward (in the short term). But that is far from saying that it has spelled the end of bull runs

In fact, according to this graph, we are most probably seeing the end of the rise in bond yields. The top graph shows the distance of the daily 10 year Treasury Notes from its 50 day moving average. As you can see, whenever it becomes too stretched to the upside, it snaps back. That’s where we are right now.

Of course, it doesn’t have to snap back. The markets are unpredictable. But the only guide we can use are observations from the past. And that is telling us that this recent fall in bond prices is right about over.

And if that does happen, it will breathe new life into the equities market.