Trader’s Narrative

On a grand scale, you could argue that the level of the stock market is set by two forces: the supply of ‘paper’, which comes from initial public offerings (IPOs), secondaries and other corporate actions, and on the other side, the demand of stocks which is not only influenced by the sentiment of investors but also by valuation and perhaps most importantly, by the supply of money in the economy.

The amount of money sloshing around the economy matters because eventually it has to find a home. In the past decade we’ve seen it rush into two markets, causing sequential bubbles in tech stocks and real estate.

One way to look at the relationship is to chart the change in change of money supply and see how it corresponds to the market and the economy. The chart below shows 35+ years of monthly data but before you can make sense of it, some explanation is needed:

Data: St. Louis Fed (FRED database)

M2 is a widely used measure of the money supply but since inflationary and deflationary periods can warp it, we look at inflation adjusted M2 (using CPI numbers). This gives us ‘real’ M2 which is more useful to compare across time. But we also have to account for the number of people in the economy because everything else being equal, on average, the more people we have the more money is used by them. So we divide the real M2 by the estimated monthly US population to get per capita, ‘real’ M2.

Then finally, we are interested in the annual rate of change that occurs in the real per capita M2 money supply, which gives us the chart you see.

The middle line represents zero, so anything above that means that the rate of change in money supply is positive and the Fed is pumping money into the economy (and vice versa). Obviously, the more extreme the move and the more the line stays above the 7 year moving average, the more significant it is.

From the latest data available (January 2009), the annual rate of change is higher than it has ever been - even higher than the early 1980’s. This means that eventually, as it works its way through the economy, there will be more and more money chasing fewer shares, driving up the level of the stock market.

Credit for this measure comes from an article by Norman P. Poiré, published in Barron’s on August 28th, 2000. If you aren’t a subscriber, you can read the article on Poiré’s website.

The mad rush into US government treasury bonds has pushed their yields to never before imagined levels. But according to the simple 1 year rate of change, we may be close or have already seen the end of this “bubble”, as this long term chart shows:

Although I think the bond market will return to its senses soon enough, US government bonds are not in a real “bubble”. But the extra-ordinary demand for US treasury bonds is at least partially responsible for the strength of the US dollar. Which I’m sure itself is surprising and confounding the gold bugs more than anyone else. After all, how can a near meltdown of the world’s financial system result in gold falling and the dollar going up? Isn’t that the exact opposite of what a sane person would expect to happen?

This recent chapter in financial history is chock full of unprecedented extremes and “Black Swans“. Among them, the yield inversion between equities and treasury bonds (Bloomberg):

Something that we haven’t seen in 50 years. And something that was just as jarring when it was witnessed in 1958. The sharp drop in rates is half the explanation, the other half is the dramatic rise in stock dividend yields.

Most market watchers are perplexed about what this means, if anything. The only explanation offered which makes some sense comes from Cliff Asness of AQR Capital:

From the 19th century through the mid-20th century, the dividend yield (dividends/price) and earnings yield (earnings/price) on stocks generally exceeded the yield on long-term U.S. government bonds, usually by a substantial margin. Since the mid-20th century, however, the situation has radically changed. In addressing this situation, I argue that the difference between stock yields and bond yields is driven by the long-run difference in volatility between stocks and bonds. This model fits 1871-1998 data extremely well. Moreover, it explains the currently low stock market dividend and earnings yields. Many authors have found that although both stock yields forecast stock returns, they generally have more forecasting power for long horizons. I found, using data up to May 1998, that the portion of dividend and earnings yields explained by the model presented here has predictive power only over the long term whereas the portion not explained by the model has power largely over the short term.

More about the relationship between dividend yields and US treasury bonds:

John Mauldin: Two Little-Noted Features Of The Markets And The Economy
Bloomberg: S&P 500 Payout Tops Bond Yield, a First Since ‘58: Chart of Day
Barron’s: Reversal of Fortunes Between Stocks & Bonds
Mark Hulbert: Stocks vs. bonds

Going back to the end of November 2007, the bond market was giving a great signal that a rally in the equity markets was about to unfold. From the time I wrote about it to its top in December 2007, the S&P 500 Index gained 100 points (1410 to 1510). That may not seem like much in today’s topsy turvy market. But you have to remember that back then the VIX was at ~20.

The idea is that the rate of change in the bond market has a bearing on the equity market. I first read about this in Mark Boucher’s book, The Hedge Fund Edge where he outlines dozens of similar ideas.

Put simply you buy when the rate of change in the 30 year bond yield is less than or equal to 9% and sell when it is above that level. The performance for this simply system is impressive. Equally impressive is that doing the opposite isn’t profitable. This is a sign that we aren’t data mining but dealing with an inherent relationship in the financial markets.

I use a variation of this system, however, the most recent signal didn’t work and I suspect it had to do with the craziness that we’ve seen in all financial markets:

Copper is famously said to have a Ph.D. in economics. So let’s see what Dr. Copper says:

By now you’re hard pressed to find anyone who won’t be bracing themselves for an economic slowdown. And that is reflected in the historic low of American’s satisfaction levels.

Interestingly enough, when the annual rate of change of copper futures goes into the negative, it signals a recession.

Of course, the National Bureau of Economic Research conveniently labels them after the fact. So we know that officially there was a global slowdown in 1998. And one that lasted from 2001-2003. Notice that this time though the rate of change is much deeper into the red.

Stock market investors and traders who are looking for a bull market may be mollified to know that the market is a forward discounting mechanism. So somewhere between 6-8 months before we are going to see an improvement in the economy, unemployment, real estate, etc. the stock market will shake off the bear market.

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.