We tend to throw quite a bit against the proverbial wall on a daily basis. So much, in fact, that often the forest gets lost for the trees as we hammer away at small points and details without fully and clearly explaining what in the heck we are working towards. So… we are going to start things off today with a bit of an overview.
One can imagine any number of potential outcomes but from our point of view most of them would fall into one of three categories depending upon the future direction of long-term U.S. Treasury yields.
The first outcome would be that long-term yields continue to decline below the lows set last December. This is the deflation scenario and it argues for being long cash, ultra-high quality bonds, and perhaps gold. If one is going to be long equities then stick with large cap, blue chip, no credit needs or concerns, steady growth, dividend paying names.
The second outcome would be that long-term yields bottomed in December and will resolve higher over time. In other words we approached the deflationary abyss and then backed away. The second outcome actually is split into two sub-outcomes.
In a normal markets cycle the low for yields set last December would initiate a rising trend for equities. If this was the case then one should sell bonds, large cap consumer stocks, and the U.S. dollar while loading up on commodity producers, financials, Asia, and the commodity currencies.
The third outcome would be that bond yields bottomed in December but the economy is in such dire straits that there will be a lagged response between rising interest rates and a recovery in the cyclical sectors. This is the argument that we have been making over the past number of months. We believe that yields bottomed in December and we also believe that the currency, equity, and commodity markets are going to trade as if bond yields are still falling.Below we show the yield spread between 10-year and 3-month Treasuries from 2000 and the SPX from 2002- 2003. In yesterday’s issue we argued that the yield curve inverted for close to 5 months in 2000 while the stock market spent 5 months making a bottom between the autumn of 2002 and the first quarter of 2003.
We show below the 10-year minus 3-month Treasury yield spread from 2006- 2007 and the S&P 500 Index from the current time frame at right.
It could be pure coincidence that the stock market worked through a bottom around the end of 2002 that lasted almost exactly as long as the yield curve was inverted back in 2000 but the idea does fit in very nicely with our thesis.
The argument would be that the yield curve turned negative or inverted in 2006 and remained inverted for close to 9 months until it finally swung positive in May of 2007. This would suggest at least the potential for a fairly lengthy bottoming process for the equity markets that would extend from October of last year through the first half of this year.
So… either yields reached bottom last December or they will slump to new lows this year. We have argued that they have bottomed. Either the stock market responds immediately to rising yields or it lags. If it responds immediately then the Hang Seng Index and Shanghai Composite Index will resolve higher from the lows reached late last year. The Canadian and Australian dollar will resolve higher. The financials should be stronger, gold prices should be weaker, and the cyclicals should outperform the consumers.
What has happened since last autumn?
This is where it gets a bit more interesting. The Shanghai Comp. turned higher, money began to move back into the cyclicals (i.e. the consumer/cyclical ratio shown below began to weaken), the U.S. dollar stopped rising, and money began to push back towards the Canadian and Australian dollars. In other words the markets did exactly what they should have done in response to the start of improving cyclical growth indicated by a rising trend for long-term interest rates.
The problem that we had with the initial reaction was that it has been our experience that on occasion the stock market diverges from the bond market. We are not arguing with the merits of shifting back towards the cyclical sectors but rather are arguing that it is still too early to do so.
In terms of the S&P 500 Index our view is that it reasonably close to a bottom. It is our view that the broad range is from 775 up to 1550. We would not be surprised if the SPX tested or even broke below the November lows around 750 but, on the other hand, we would also not be surprised if this proved to set THE bottom.
Our view is that we have finally reached what we have called the ‘split’ point. By this we mean that the equity markets have reached a point where on weakness some stocks make new lows while others do not. On rallies the weaker stocks will rise only to fall once again to new lows while the stronger sectors will gradually resolve higher. In other words instead of all stocks and all sectors declining to new lows together- which is essentially how the SPX got from 1550 to below 800- there will be sectors that rise in absolute terms even as the cyclicals decline in absolute terms. The net result will be- over time- a ‘wash’ that helps keep the S&P 500 Index within the general vicinity of current levels through into mid-year.
We very rarely change our macro views because, we suppose, that is the point and purpose of macro views. We liked the consumer and health care (including medical products and biotech) sectors last year and we expect that this won’t change for at least a few more months.