The trend is so close to tipping over into something substantially more serious that we are inclined to view things from a ‘half full’ perspective today. In other words we are going to focus not on why the markets have to dig and improve but instead on why they might.
If one were viewing the markets from the point of view of the yield curve then where things stand today is actually very similar to the stock market’s cycle bottom in the autumn of 2002. Let’s start with this little bit of encouragement.
The yield curve inverted in both 2000 and 2007 as long-term yields fell below short-term yields. The chart below shows the S&P 500 Index as well as the yield spread between 10-year and 3-month U.S. Treasuries.
Once the yield curve inverted in 2000 it widened dramatically as short-term yields collapsed. There was a period of time, however, through 2002 when the yield curve narrowed in as the result of the marked decline in long-term yields. The chart shows that the spread moved from a peak around 35 (3.5%) down to a bottom very close to 20 (2.0%).
The S&P 500 Index continued to decline through late September and into October before moving into the start of a new bull market once the yield spread started to rise once again.
Next we show the same comparison for the current time period. The argument is that after the yield curve inverted in 2007 and then widened sharply through 2008 it is now squeezing lower with the equity markets in a manner almost identical to 2002.
The chart shows that the yield spread peaked this past spring around 3.50% (similar to the spring of 2002) and has recently contracted all the way back down to 2.0%.
The basic argument would be that while the S&P 500 Index could quite easily decline in the short run… the yield curve squeeze from 3.5% down to 2.0% has largely been accomplished and… the next time the yield curve starts to steepen once again through rising long-term Treasury yields instead of the beginning of a bear trend we could very easily be at the start of a prolonged bull market recovery.
Equity/Bond Markets
The chart comparison below features, from bottom to top, the Bank Index (BKX), the ratio between equities (S&P 500 Index) and bonds (U.S. 30-year T-Bond futures), and the ratio between gold and the CRB Index.
Obviously… the Bank Index could make new lows this month. The ratio of equities to bonds could also make new lows while at the same time the price of gold relative to general commodity prices could also make new highs. But… any time the markets act as if they are in the process of falling apart and key relationships such as the ones shown at right are still within recent trading ranges… there is reason for short-term optimism.
We stacked these three charts because all have the potential to be ‘head and shoulders’ reversal patterns. It won’t be the end of the world if the markets refuse to pivot today but it would make for an interesting scenario if the Bank Index were to resolve back up above 40 some time in the next few trading sessions given that this would have to go with both weaker bond and gold prices.
The chart below shows the spread or difference between the Amex Oil Index (XOI) and the S&P 500 Index (SPX).
The spread between the XOI and SPX bottomed in early 2000 at the very peak for the Nasdaq. At that time the SPX was more than a 1000 points higher than the XOI.
The spread rose in favor of the oil stocks into 2008 until the XOI was more than 200 points higher than the SPX.
If we draw a trend line below the spread line then a case can be made that the ‘positive energy trend’ is still intact simply because the trend line continues to act as support. On the other hand all it might take to break the last decade’s most pervasive and dominant theme (strong energy prices) creating a host of new sectors for markets leadership (energy users, Japan, etc.) would be one more downward hit for energy prices.
