We heard it again yesterday.  It was said earnestly and with great conviction and the arguments that followed were definitely quite thoughtful. It made sense and it was believable. It was also something that we have heard on many occasions over the past few decades.

The Fed, we were told, is pushing on a string.

There are two statements that one can always expect to hear at some juncture in every markets cycle. The Fed is pushing on a string and it is a jobless recovery. Why? Because the lag between when the Fed starts to ease credit and when it shows up in the markets is considerable and the lag between improving financial asset prices and traction in the real world is somewhat extended as well. That is why it makes more sense to forecast the economy off of the stock market instead of  the other way around.

Below is a chart comparison between the S&P 500 Index and the sum of 3-month and 10-year Treasury yields between 2000 and the end of 2005.

The Fed started to cut the funds rate in January 2001 and made its initial rate hike in June of 2004.

The first point is that the Fed lags the markets. The funds rate was cut after the trend for the SPX had turned lower and was increased more than a year after the stock market had turned higher.

The second point is that the Fed seems to follow the long end of the bond market by close to a full year. Long-term yields turned lower in January of 2000 with the funds rate reduced a year later. Long-term yields turned higher in mid-2003 with the funds rate starting to rise in mid-2004.

The third point is that while interest rates have been weaker of late- creating a sense to impending doom through the equity and commodity markets- the real point in time worry was 2007- 2008. We are now a few years past the 2007 cycle peak and in a position roughly the equivalent of 2003. That was a point in time, of course, when many argued that the Fed was pushing on a string and that this was indeed a jobless recovery. Our view? Monetary policy works with a lag and while the current lag may prove to be longer than those of previous cycles the economy will find traction in due course, the stock market will lead the recovery, and jobs will ultimately be created.

Equity/Bond Markets

We are going to wind through a rather complicated and convoluted argument that is going to require two pages to complete. To cut to the chase, however, the idea is that things aren’t as dire as many believe.

To start things off we are going to return to a chart comparison that we showed on many occasions in these pages some months back. The original charts showed the S&P 500 Index, crude oil futures, and the U.S. 30-year T-Bond futures from late 1985 through 1987 and from 2008 forward.

We have removed crude oil futures from the charts to simplify the picture somewhat. However the trend for crude oil prices represents the foundation of the argument. Otherwise the lines and notations on the charts remain unchanged.

Here goes...

In late 1985 crude oil prices collapsed. During the second half of 2008 crude oil prices collapsed. Different decades and different circumstances but in both cases the dramatic decline in energy prices sparked the beginning of a rotation within the markets.

Crude oil prices started to decline in late 1985 and bottomed in April of 1986. Crude oil prices started to decline in July of 2008 and bottomed in December of 2008.

We mark the bottom for crude oil in both 1986 and 2008 as the peak for  long-term Treasury prices. In other words the spike top for the U.S. 30-year T-Bond futures in 1986 represents the cycle lows for energy prices while the highs in December of 2008 mark a similar energy price bottom.

Energy prices collapse. Bond prices rise. April of 1986 is the equivalent of December of 2008. Fair enough.

After bond prices hit a high in April of 1986 the stock market shifted back into a positive trend that ultimately led to a cycle peak for equities in August of 1987.

When we were showing this comparison earlier this year the idea was that if the sequence of weak energy prices, strong bonds, and recovering stocks were to repeat... the S&P 500 Index was forecast to reach a peak some time during April of 2010.

With the benefit of a few months worth of hindsight... that wasn’t such a bad call. For as random as all of this might appear the reality to date is that the S&P 500 Index made a clear top this past April. With this in mind we thought that it might be worth the effort to take the argument a few steps further because what is important today is NOT what happened a few months ago but instead what will happen a few months from now.

The big difference, by the way, between 2010 and 1987 is that the stock market did not ‘crash’. We suspect that this has much to do with what happened in the bond market AFTER the SPX reached a high. In 1987 bond prices continued to decline until the equity markets collapsed while in 2010 the bond market pivoted higher as soon as the trend for equities began to wane.

In any event... if April of 1986 (bond market top) was the equivalent of December of 2008 (bond market top) then August of 1987 (stock market top) lines up with April of 2010 (stock market top).