Trader’s Narrative

In early June I stumbled on a promising indicator for finding market tops. As a student of the markets I’ve desperately searched for a reliable tell for tops. But for the most part the prey is elusive.

Market bottoms are much, much easier to find than tops. The VIX index pops, the put call ratio spikes, sentiment goes haywire, and on and on. There are literally dozens and dozens of indicators that one can line up as good signs of a market bottom.

The indicator that I mentioned involves the interplay between the stock market and the bond market. As the rates in the bond market rise, the stock market usually suffers because money starts to flow out of equities and into less riskier (and higher yielding) bonds. And vice versa.

It is simply, the 30 day rate of change of the 10 year Treasury Bond yield. When it approaches 9% (or more), the stock market tends to get weak. Especially when immediately prior to the signal it has been on an uptrend.

This is what we had in early June 2007 and so far, the signal has been good. I suppose we could argue whether the June high water mark is truly a “top” or whether it is simply a pause. To really know, we need more time. Still, one can’t argue that entering at that time wasn’t a good idea since it wouldn’t have made you any money. In fact, exiting to preserve capital seems to have been rather smart.

Of the major market proxies, the Nasdaq composite is the only one that has surpassed its early June highs. The Russell 2000 Small Cap index, the Dow Jones, and the S&P 500 have all traded within a range.

But I’m still rather bullish for the intermediate to long term time frame. I’ve shared with you a few reasons for that. Most recently, the remarkable Commitment of Traders report, the short interest ratio and finally the total apathy from retail investors. The fly in the ointment continues to be the flacid financials.

Earlier this month I mentioned the IBES valuation model and how it was telling us that US equities are extremely undervalued. The Barnes Index is another valuation model which is similar to the IBES.

Keep in mind that these valuation models are really broad strokes. They are not meant for nimble, short term traders. They attempt to outline the general tone of the market and perhaps its long term trajectory.

So what is the Barnes Index? Like the IBES model it compares the stock market to the bond market. But unlike the IBES it considers both the short term yield and the long term yield (the yield curve in other words):

Barnes Index = (Treasury Bond Yield X Treasury Bill Yield) divided by (S&P 500 Dividend Yield X S&P 500 Earnings Yield)

So in essence it pits the “returns” from stocks, in the form of dividends and earnings versus the “return” (yield) from bonds. Market risk is highest when you can make more by investing in risk-free assets. The normalized chart below comes from Decision Point (the excellent technical analysis service run by Carl Swenlin).

Click to Enlarge Graph

Since it began in 1970, the Barnes Index gives us a few more years than the IBES model. The last buy signal was given in early 2003, at the bottom of the bear market. At its current level, it is neutral.

In 1973, when the Barnes Index was also at similar levels, the market topped. Also in 1981. But then again, in 1990-1 although it stood where it does now, the market went much higher.

Notice that similar to the IBES the model imploded into irrelevance due to the “bubble years”. In 1997 it crept into the redline and stayed there almost constantly until late 2001. Which proves that no model or forumla can ever predict or explain the market. All we can ever hope for is a crude approximation.