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July 21, 2009

Weekly Wrap-Up: Different Time Frames, Different Outcomes
by Adam Oliensis

Dear Speculators,

The following article was originally published at The Agile Trader (www.theagiletrader.com) on Monday, July 21, 2009. If you would like a free one-month trial to our twice-daily service, please click HERE and then click the red "subscribe" link at left.

To begin this week, I'd like to examine where some important stock- and bond-markets are on their weekly charts. I wrote recently about the extremely high volatility in Treasuries, and that volatility has persisted,. The 10-Yr Treasury yield (TNX) rose 36 basis points last week to 3.65% (and it's tested up almost to 3.75% today, Monday).

As you can see, the long-term trend zone here remains downward (yields lower, bond prices higher). But the recent climactic low on TNX, near 2%, did not reach all the way down to the lower limit of the trend zone. So, we have some indication that, as the chart approaches the zero bound, the lows for the secular trend may have been achieved, and that we're now due (at least in part as a function of aggressive liquidity-pumping, both in terms of monetary and fiscal policy) to see a long, arduous, scalloped rise on this chart.

If the US economy is headed into a "nuclear winter," then we may see 2% revisited. But if the recovery has some legs, then we'll likely see 4% again, and then 5%, over the next year or two.

Turning to the shorter-term picture, the >35-basis-point weekly rally in TNX (from about 3.3% to about 3.65%) was in the 98.8th percentile of all weekly rises, going back 15 years. Most of the other rallies of equal or greater magnitude in such a minimal period immediately followed memorable crises: the crash of October '98, 9/11, and the launch of the Iraq war in '03.

The extremely high volatility of risk-free long-dated yields (also partly a function of huge supply offered by the Treasury to pay for fiscal stimulus, as well as of the fear that foreign central banks will diversify out of dollar-denominated Treasuries) continues to be a problem for assessing value in "risk assets" (like stocks) especially insofar as risk-asset pricing is significantly predicated on the value of those risk-free assets. Or, put more simply, if the market doesn't know what bonds are worth, how's it going to know what stocks are worth?

And, yet, recent strength in the stock market suggests increasing confidence in stock valuations, despite gyrations in bond pricing.

What's unusual about the current bout of Treasury-yield volatility is its persistence. It remains to be seen whether underlying confidence in the security and "risk-free-ness" of Treasuries is being significantly undermined...something that we'll find out for sure only in the fullness of time. A calming down of volatility in Treasury yields would be a welcome change of character (bullish) for the stock market.

The SPX's rally up from its March lows, while powerful (about a 40% pop), remains below the level of a 38% retracement of its '07-'09 decline. In that context, it remains fair to maintain at least some doubts about whether the rally off the March low is the inauguration of a cyclical bull market or merely an aggressive bear-market rally.

A break of the neckline of the Inverse Head & Shoulders bottom (which would be a move up through the 960 area), would open the door to completion of the 38% retracement (to 1014), and would then put a target up near 1200 on the table. Intermediate resistance would likely come into play at the level of 50% retracement of the bear market (1021), with the 62% retracement target at 1229, and very close to the 1200 target.

Of some concern to the bullish case (or it should be, anyway) is that the rally up from the March lows has come on steadily declining volume. This trend suggests waning commitment on the part of the buyers. And it would take a surge in volume on a break above SPX 960 to obviate the negative implications of that recently waning commitment.

The NDX weekly chart is somewhat stronger. The NDX has broken through the 38% retracement level, having rallied up through 1485. And volume has been less obviously on the wane on this chart than on the SPX chart above.

Assuming that 1485 now holds as support, the level of a 50% retracement of the '07-'09 decline would carry the index up to 1629. And a 62% retracement would target NDX 1773.

Should 1485 break to the downside, then lower targets would be in play again: e.g., 1436 and 1340.

Since we've been looking at Treasury yields and stock-market performance, I'd like to show you an interesting chart that that exists at the nexus of these 2 subjects. On this chart the blue line is the yield curve, in this case defined as the difference between the 10-Yr Treasury yield (TNX) and the Effective Fed Funds Rate (FFR). As of Friday, the blue line was at 3.526%, which, as you can see, is a very high level.

That means that the TNX is much higher than the FFR. Consequently, there is great incentive for banks to borrow short term and lend long term, as profit margins for doing so are high. This high level of incentive for lending tends to be stimulative to the economy.

The pink line on the chart is the forward 2 ½-yr annualized price appreciation of the SPX. When the pink line is low, that means that over the ensuing 2 ½ years the SPX price did not appreciate much (or may have declined). And when the pink line is high, the SPX rallied strongly over the ensuing 2 ½ years.

I've put yellow bubbles around the major trough areas of the pink and blue lines. And I've put green bubbles around major peaks on those lines. And, as you can see, there are pretty good correlations between the troughs on the two lines, and between the peaks on the two lines.. (Not perfect, but pretty good.)

What does this chart mean? Well, to my eye, it suggests something that we basically assume to be the case, which is that when the yield curve is steep, the stock market tends to perform well over the next couple of years, and that when the yield curve is either shallow or inverted (below 0%, which means that the FFR is higher than the TNX), the stock market tends to perform either much less well or much more poorly.

And the specific application to the present? Well, the inversion of the yield curve (blue line below 0%) that took place between June '06 and Jan. '08 had the effect that it "should" have had, which was to push the pink line down into an important cyclical low. And now that that cyclical low has begun forming in the stock market, the extremely steep yield curve (high blue line) suggests that over the next 2-3 years, the stock market has an opportunity to show extremely strong price appreciation.

The stage is set for a cyclical bull market.

But what has to happen in order for the very steep yield curve to actually have a salutary effect on the economy? The very steep yield curve has to function as sufficient incentive for banks to actually borrow short term at low rates and lend longer term at higher rates.

The fly in the ointment right now, as I see it, is that the commercial real-estate market is suffering an accelerating set of problems (as I've mentioned briefly in our daily work when discussing CIT's flirtation with bankruptcy). And if these problems continue to be exacerbated (as they very likely will be), that will pose a whole new set of problems and stresses for the Financial sector.

Our last chart plots Moody's Real Commercial Property Price Index (black line) along with the index's Y/Y change (pink area) and its M/M change (red bars).

The latest data (May) records a decline of -8.6% M/M in price. The Y/Y change is about -25%. And, there's nothing in the data right now to suggest that the 2nd derivative (rate of change of the rate of change) is decelerating.

The mortgages on these properties have been securitized and sold, just as was done with residential mortgages. And these securitized mortgages (bonds) sit on the balance sheets of (mainly Financial) companies. The precipitous declines in commercial real-estate prices, then, will be translated, with leverage, onto the balance sheets of these companies. Those real-estate price declines generate additional capital requirements for the companies that hold these bonds, since the bond prices will decline along with the prices of the underlying real-estate assets.

Declining commercial real-estate prices leave the door wide open to an "echo credit bust." One that could force the economy to suffer a "double dip" recession as a function of a freezing up of lending.

So, curiously, we have the stage set for 2 distinct outcomes, in differing time frames. Clearly, monetary and fiscal stimuli are working at "full-tilt boogey" to reflate the economy and the stock market. But, just as clearly, the potential exists for another problematic episode in the ongoing saga of the credit market's woes.

In a time frame of 2-3 years from now, the odds favor that the economy and the stock market's being in significantly better shape than they are now. But, in the nearer term, say, between now and October, risks remain acute of there being another nasty chapter in the recovery story.

Best regards and good trading!

Adam Oliensis,
Editor The Agile Trader

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