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.

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.