We are going to focus on ‘the trend’ today.

One of the challenges that the markets throw our way has to do with ‘lags’. In particular the lagged response by the real economy to changes in interest rates and the lagged response by the economy to changes in the trend for financial asset prices.

To explain... we start off with the chart at top right from late 1999 into the summer of 2001. The chart compares 10-year Treasury yields, the sum of copper (in cents) and crude oil (in dollars times 3), and the ratio between medical products maker Abbott Labs (ABT) to the S&P 500 Index.

In January of 2000 10-year Treasury yields peaked and began to trend lower yet the sum of copper and crude oil continued to rise through the third quarter of the year. Did energy and metals prices rise because yields were falling or, perhaps, were falling yields an indication that slower growth would eventually show up in the market for raw materials  prices? We side with the latter explanation.

The falling trend for yields was ‘confirmed’ by the rising trend for the ABT/SPX ratio. In other words money began to shift towards less economically sensitive sectors as soon as yields began to decline.

Our view is that when yields turned lower in early 2000- confirmed by the rising trend of the ABT/SPX ratio- the markets were saying that growth was slowing. Yet it took the ‘real world’ (copper and crude oil prices) at least 9 months to get the message.

At bottom right we show the same comparison for the current time frame.

Obviously yields are trending lower. The problem is that there has been so little strength in the sectors that usually begin to outperform when yields turn lower that at best we may only be a few months into the process. Put another way if the ABT/SPX ratio is supposed to turn higher confirm a slowing growth trend then the trend change began some time around the start of this year’s second quarter.

The point? We have been arguing in favor of cyclical strength into year end. In terms of this comparison this could simply represent a nine month lagged response between the start of falling yields and the commodity markets realization that the underlying trend has already turned negative.

Equity/Bond Markets

We have any number of problems with the markets but somewhere close to the top of the list is our uncertainty about where we exactly are in terms of the trend. In other words... are the equity markets near the top of a bull run that began back in 2009? Was the rise merely a rally in a bear market? Is the bull market over or, perhaps, are we closer to the end of the bear market?

The answers to these kinds of questions are obviously quite important. One would think that it should be obvious given the length of time that has elapsed since 2008’s markets melt down but... it really isn’t. It depends in large part on the perspective used.

Take the share price of Netflix (NFLX) as an example. In late 2008 the stock was trading below 20. Recently it has risen to a peak just above 140. If a growth stock is capable of increasing by a factor of 7 times in just over 18 months can this really be a bear market?

Yet if you view the markets in terms of something like lumber futures which peaked way back in 2004 when the Fed began to tighten credit in response to rising energy prices the trend still looks lower. If you use any number of large cap U.S. equities to ascertain the trend you might come away with the perspective that the bear market began as far back as 1999- 2000.

In any event we thought we would show a slightly different perspective today. Below is a chart comparison between 30-year Treasury yields minus 5-year yields and the product of the S&P 500 Index times 10-year yields.

The 30- 5 yield spread is simply another way to view the slope of the yield curve. In recent months the yield curve has flattened substantially  with most of the pressure coming from shorter-term yields. For example... Aug. 19 (Bloomberg) — U.S. two-year note yields fell to a record low after the Federal Reserve Bank of Philadelphia’s general economic index dropped and weekly unemployment claims unexpectedly rose, adding to evidence of a faltering recovery.

Within the yield curve, however, the message is still somewhat mixed.  The spread between 30-year and 5-year yields has only just recently reached what might prove to a cycle top.

The argument is that a ‘bear market’ begins when the spread bottoms and starts to rise as it did in 2000 and again in 2007. The ‘bear market’ ends when the spread reaches a peak.

A ‘bull market’ begins in earnest when the spread between 30-year and 5-year yields flattens out or declines to the point where the 50-day e.m.a. line crosses down through the 200-day e.m.a. This won’t catch the bottom for the equity markets but will help to confirm that the trend has truly turned positive.

Keeping in mind that equities are financial assets which means that valuations expand as interest rates decline a ‘bear market’ in terms of this comparison includes any time frame when the SPX times 10-year yields is falling. A ‘bull market’ represents a rising trend for the SPX times yields.

The point is that the 30- 5 spread reached a new peak this month which argues that we are still mired in the ‘bear market’ trend that began way back in 2007. We note that once the spread reached a peak in late 2002 the SPX times yields combination had effectively reached a bottom. To turn the trend positive, however, requires either higher 5-year yields or, more likely, even lower 30-year yields. In other words... a case can be made that falling long-term yields may prove to be the equity market’s salvation this year.