Trader’s Narrative

Here is a great illustration of the point I made earlier about how NYSE breadth numbers can be misleading because they are now skewed by interest sensitive non-common stock securities (such as bonds, CEFs, munis, etc.).

Here is a chart, courtesy of SentimenTrader.com, which shows the movement of the 30 year bond yield compared to the long term moving average of the NYSE advance decline numbers:

As you can see, they usually are mirror opposites of each other. When one is making a bottom, the other is making a top and vice versa. Of course, it isn’t a perfect correlation because the NYSE isn’t comprised of only interest rate sensitive issues. There are still many common stock securities which also have an effect on the breadth numbers. But it is obvious that what we are seeing is a blending of the two forces.

Here is a more up to date chart of the same showing the last 3 years:

Ho-hum. You know, another day. Another all time high.

But wait, what’s that creeping higher and higher. It’s the bond yield. Both the 10 year and the benchmark 30 year bond yields are getting up there. There is a lot of chatter now about how this is a bad omen for the equities. The logical explanation is that bonds compete with equities for money. When they are cheap enough (yields high enough) people will prefer to buy them instead of equities.

This reminds me of one of the first trading books I read: Mark Boucher’s “The Hedge Fund Edge”. I recommend it highly. Boucher introduced me to the concept of technical analysis and for that I’m eternally grateful. He only gives it a cursory treatment but it was enough to whet my appetite. I went on to read countless technical analysis books. Another important concept Boucher taught me was the liquidity theory or the liquidity cycle from an Austrian school of economics point of view.

To show how real it is, he produces some trading systems that rely on the bond market for signals. I’ll share two with you (you really should pick up a copy).

The first looks at the 12 month rate of change of the 30 year bond yield. If it is equal to or less than 9% you buy the S&P 500. You exit when the yield is greater than 9%. Since his book was published in the late 1990’s it covers January 1943 to the end of 1997.

The result of the system is an annual return of 14.8%. The worst position was in 1974 (-11.93%). Interestingly enough, this system is only invested 64% of the time. So you could have even higher returns if you plopped your money in a money market fund the rest of the time.

The inverse system (buying the market when the ROC is more than 9% and selling when it is equal to or less) provided a -0.9% return. So atleast according to this system, there is real world evidence of the efficacy of liquidity theory.

The second bond system Boucher mentions is based on the yield curve. The rules are to buy the S&P 500 when the ratio of the 30 year bond yield to the 3 month bond yield is greater than 1.15. And to sell when it is equal to or less.

The system covers the same time as the first one and similarly, is only invested 63% of the time. Yet it produces an astonishing 19% annual rate of return. And even more astounding, the worst trade is only a loss of 3.81%.

I know what you’re thinking, where are we according to these systems right now?

The 12 months rate of change of the 30 year bond yields is at 8.70%. And the 30 year yield to the 3 month yield is at 1.058 right now.

Here’s a graph of the most current 30 year bond yield rate of change (12 month) and the S&P 500:

I’ll write some more on the bond market and its implications for the equities market over the weekend. Until then.

The yield curve is a sign of liquidity and as such, has provided good signposts for the long term prospects of the stock market. So lets take a look at what the yield curve looked like at the top and bottom of the markets. And what it says now.

The first chart shows the yield curve. The first line (burgundy) in the chart is the flat to negative yield curve we saw at the market top in March 2000. The other line (red) is the very positive sloping yield curve we saw at the bottom of the bear market in March 2003 (there was a temporary suspension of 30 year bond auctions during that time which is why you don’t see data for that security).

And now, we are once again seeing a flat to negative yield curve similar to the 2000 top (not shown on graph). Does this mean that the market is in trouble?

Maybe. But not necessarily.

You have to remember that the Federal Reserve, unlike the myth they like to perpetuate, doesn’t really control anything. Instead, they do their best to mimic the dictates of the bond market.

The short term, 90 day bond rate bottomed in the summer of 2003 and rallied almost non-stop. But beginning last year and continuing this year, it has put in a beautiful rounded top formation. And just recently the 90 day T-Bills rate carved a triple top and then fell through support at 4.75%.

This is the largest discrepancy between it and the Fed funds rate since right after September 11, 2001. The clear message of the bond market is a Fed rate cut.

Which would will reshape the yield curve to once again be positively sloped.