Trader’s Narrative

If you are trying to time the stock market, you obviously have to take a look at and analyze the stock market. But a little followed indicator that has nothing to do with the stock market has historically provided amazing insight into future equity returns.

For those unfamiliar with it, the yield curve is the visual snapshot of the interest rate of different maturities of government bonds and notes. The condition of the yield curve is described by comparing the short term to the long term. There are usually three general states or categories: normal, inverted and flat. But there is also another: a steep yield curve.

Steep Yield Curve
This fourth state is usually rare but that is what we are seeing now. The 20 year treasury note currently yields 4.45% , the 10 year treasury note 3.8% and in contrast, the 90 day or 3 month treasury note is currently yielding 1.45%.

So the current differential between the 20 year note is 3.05% and the 10 year note 2.35%. During the mid-March 2008 market upheaval, the 20 year and 90 day treasury yield difference ballooned to 3.54%. Since the historical differential for the 20 year note is appx. 2% and the differential for the 10 year note appx. 1.35% this qualifies today’s yield curve as a steep yield curve.

Powering the Stock Market
So what? Why should you care if some esoteric fixed income construct like the yield curve is steep?

Because the yield curve has some heavy real world significance. It is a symbolic representation of how money filters through our economy and how it creates the prerequisites for economic growth.

According to the editor of the Systems & Forecasts newsletter, Marvin Appel, the S&P 500 performs best when the difference between the 10 year treasury note and the 90 T-Bill is between 1.41% and 2.57% with the following week providing an unheard of 13.3% return.

With the Federal Reserve’s 25 basis point rate cut yesterday, we now have a perfect ski hill. Notice the difference between it and the yield curve on July 16th 2007 - when the market topped out.

October was another high but for all intents and purposes, the market reached a peak that it didn’t surpass in July. The point is that the yield curve has predictive qualities when it comes to tops as well. Almost all important tops, as well as recessions, have been signaled beforehand.

What today’s yield curve is telegraphing is that the economy is about to kick into gear (again). A steep yield curve is usually observed at the end of a recession and/or just before major economic expansion. Sure, that may sound like crazy talk with all the bad news floating around. But that is how the market works. Everything is priced in. The bond market is, for the first time, holding the 90 day T-Bill rates steady even as the Fed lowers rates to meet it.

Looks like the puppy finally is willing to get caught. The gap between the 90 day T-Bill and the Fed rate is now down to just 54 basis points.

The huge and continuing gap between these two caused me to write that the Fed should cut rates immediately way back in June 2007.

Then, as now, I couldn’t believe what I was actually writing. But I had to remind myself that I wasn’t making this up. It wasn’t mere opinion, it was the market talking.

Want to see something that will knock your socks off?

US Financial Stress Index
The BCA US Financial Stress Index (left) is a proprietary and nutritious blend of these econometric and statistical ingredients:

• performance of bank stocks relative to the general stock market
• the yield curve
• credit spreads
• real stock prices
• consumer confidence
• market leverage
• private debt
• new bond issuance
• new equity issuance

BCA Research is the world re-known financial markets analysis firm out of Montreal. According to this indicator, the only previous crisis in recent history to outdo our present subprime debacle is the Savings and Loan boondoggle that was the epitome of the 80’s excess.

Which would explain why BCA Research is not giving up on their bullish bias:

The long running bull market in equities is not dead yet. The Fed is not the only game in town. The U.S.economy is not falling apart, the dollar has cheapened substantially and bond yields have melted. Most important, equities offer good value and the areas most exposed to the subprime crisis are already attractively priced.

If you’re still wondering how the Sub-Prime mess came about, there is no simpler explanation than this.

Here’s a more serious one (don’t forget to check the “How it went wrong” checkmark).

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.

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.

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.