The first three sections of today’s issue are going to deal with our thesis regarding how the markets are going to evolve over the next year or two. We are not writing that this is exactly how things are going to unfold but… it does make for a nice thesis. A
Our jumping off point is based on an argument that we littered these pages with through the second half of last year. At top right is a chart of the sum of 3-month and 10-year Treasury yields from 2007- 2009 while below right is a chart of the S&P 500 Index times the CRB Index from 2009 to the present day.
We are using the sum of 3-month and 10-year yields to represent the broad trend for interest rates. In the past we have used 30-year T-Bond futures prices to represent this trend but in recent years we have used the combination of short-term and long-term yields as our proxy.
The argument is that while interest rates and cyclical asset prices tend to trend together in ‘real time’ there is also a lagged relationship. The trend for interest rates seems to lead the trend for cyclical asset prices by very close to 2 years.
The combination of the SPX times CRB Index is simply one measure of ‘cyclical asset prices’. We have used a number of other proxies for this theme over the years but for today this is as representative of what we are attempting to show as anything else that comes to mind.
If the bond market leads cyclical asset prices by two years then the trend for yields two years previous should have something to say about the current trend for cyclical asset prices. For this reason the two charts at right have been shifted or offset by two years so that declining yields in 2007, for example, line up with rising equity and commodity prices in 2009.
The argument last year was that tumbling yields during the second half of 2008 should lead to a very strong cyclical trend through the final six months of 2010. This was virtually our daily mantra and one can see that for all intents and purposes… we nailed this one. Quite nicely actually.
The issue, however, is not what happened last year but instead what is going to happen… next.
Equity/Bond Markets
The charts above make a rather compelling case. They argue that if there really is a 2-year lag between the trend for bond prices and the trend for cyclical asset prices then it may well have run out of momentum close a month ago. In other words… on the surface this would seem to suggest that the momentum enjoyed from the long side of the equity and commodity markets through the final four months of 2010 has now come to an end.
If we end up being wrong we will probably hang on this very point. We are going to argue that there is still life remaining in the recovery for cyclical asset prices even though the 2-year lag rather clearly shows that the trend ran out of steam at the end of 2010.
Below is a chart of 3-month and 10-year Treasury yields from 2003- 04. Below this is a chart of the product of the SPX times the CRB Index for 2005- 2006.
The first point is that the bottom for yields was reached in mid-2003.
The second point is that by most measures the peak for cyclical asset price momentum was reached in the spring of 2006.
The third point is that there is more than two years separating mid-2003 and the spring of 2006.
If the absolute low for yields in 2003 was going to translate into the absolute high for cyclical asset prices- two years later- then the trend would have come to an end in mid-2005. By extension if the absolute low for yields at the end of 2008 was going to do the same thing then we would have to argue that we are currently at the cyclical peak.
There are two ways to deal with this. The first is to examine the yields chart at top right. There were two different bottoms for yields- the absolute bottom in 2003 and a second low reached in the spring of 2004 that marked the start of upward pressure on short-term yields. Copper prices, for example, peaked in the spring of 2006 so the charts seem to be arguing that the absolute bottom (2003) is less important than the start of upward pressure on short-term yields (2004).
Further below is a chart of the sum of 3-month and 10-year yields from the current cycle.
The chart shows that the absolute low was reached in December of 2008 leading into a six-month rally for yields. Taken literally this is the head wind that the markets appear to be facing over the first half of 2011.
The chart shows a second low for yields in the autumn of 2010.
Our thought is that this second low (end of the third quarter last year) is going to be the rough equivalent of the spring of 2004.
Our thesis is that a major trend change is going to occur two years AFTER the low point for yields in the autumn of 2010. In other words we are looking for a significant event to occur in the autumn of 2012.
