We have written on many occasions that falling interest rates are a positive for equity prices. The twist is, however, that the reason interest rates are falling is often perceived as a negative. In other words while lower yields help to expand valuations (i.e. price to earnings multiples) a concurrent recession will do enough damage to earnings to create a downward tilt for the major stock market indices.
The chart atbelow helps- we hope- to explain. The chart compares the U.S. 30-year T-Bond futures with the S&P 500 Index (SPX) futures from early 2007 to the present time period.
The chart shows that rising bond prices go with falling equity prices. The argument would be that it is not rising bond prices that is the negative but rather the reason that bond prices are on the rise. A collapsing financial system that pushes investors into the safety of Treasuries is hardly the back drop for a vibrant stock market.
Below we return to a chart comparison that we have featured in these pages on many occasions. The chart shows 10-year Japanese (JGB) bond futures and the ratio between Japan’s Nikkei 225 Index and the S&P 500 Index.
The basic point here is that Japan’s economy tipped over the edge following the asset price bubble that peaked in early 1990. As Japanese growth slowed the trend for Japanese bond prices turned positive and as Japanese bond prices trended upwards the Nikkei began to underperform the SPX. Fair enough.
The trend for Japanese bond price has actually been fairly flat through the past decade as the Nikkei/SPX ratio has pushed back and forth through roughly 10:1. One of our recurring thoughts is that one of these days… after close to 20 years of consolidation… the Japanese economy is going to kick back into gear and when this happens 10-year JGB yields are going to push back above 2.0% (compared to 1.3% at present) which will initiate a multi-year period of relative strength by the Nikkei 225 Index. In the days to come if JGB yields get anywhere close to 2.0% we will start to ramp up our ‘pro-Japan’ commentary.
Before moving on we will finish off our page 1 thoughts.
We have yet to see or read about any markets trend over the past few years that is perceived to be a positive for Japan. If the yen is weak it is because higher returns are available elsewhere. If the yen is strong then exporters’ profits will be hurt. If commodity prices are strong and rising then Japanese profits will be squeezed and if commodity prices are weaker then cyclical growth has slowed which is an even greater negative. If interest rates are falling this means that economic growth is negative and if interest rates are rising… then ostensibly this will slow Japan’s economy.
Our view is that the one thing that has to happen to signal the start of a sustainable economic recovery for Japan is a rise above 2% by 10-year Japanese yields. If an economy is going to escape from deflation then interest rates have to rise because if they don’t… then deflation is still the issue. As an aside this may in fact be somewhat relevant for the U.S. In December 10-year Treasury yields touched down to 2.1% which, we will argue, is very close to the ‘2.0%’ level. If yields move below 2.0% in the days to come then it will likely mean that the U.S. has shifted into a state of deflation and we would argue that as long as yields remain below 2.0% it likely makes sense to look for growth opportunities in the equity markets ‘elsewhere’. As long as yields remain above 2.0%, however, we can justify our focus on the U.S. equity markets.
Belowwe show two chart comparisons of the S&P 500 Index (SPX) and U.S. 30-year T-Bond futures. The chart at top right is from 1999- 2000 and… it has been scaled upside down. This one is going to hurt.
We show the same comparison from the present day below.
The argument is that 2009 is something like the inverse or opposite of 2000. In early 2000 the bond market bottomed and turned higher even as individuals scrambled into an equity market that they had to know was egregiously valued while in 2009 the bond market may have peaked as investors have moved strongly away from an equity market that by most measures offers substantial value.
Every now and then we do an informal survey of a few brokers that we know who have been in the business for close to 30 years. The question that we ask is, ‘What is the one trade that, if you brought it to your best clients, they would not agree to do?’. The odd thing is that we are constantly surprised by the answers that we receive. In mid-2007, for example, the overwhelming response was that the one thing that clients would not do is sell bank shares. At year end 2008 the answer was… buy any stock. Not buy GM, Citigroup, Fannie Mae, or even General Electric but… not buy ANY stock. The one thing that retail clients would simply not do was buy any stock in December of 2008. Given our contrary nature… we couldn’t help but feel quite bullish.
In any event… we turned the comparison below upside down so that the trend would move in the same direction as the current trend. If the TBonds continue to decline and the comparison holds we could see the SPX push up to the moving average lines over the next month or two and then potentially go through a slump into the second half.
The argument is that falling bond prices should be a positive for equities but the process of building the next bull market may take a few months given the current state of investor pessimism and/or apathy.