Research.LeutholdGroup

Having devoted all of our professional lives to the monitoring and modeling of equity markets, we’re naturally ticked off that this year’s best stock market signals have in fact been rendered by bonds.

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A couple of months ago, we (belatedly) observed that, in February the 10-year Treasury yield had bro-ken above its 10-year moving average. That simplistic tool has been a pretty good descriptor of yields’ long-term trend for more than a century, with few “whipsaw” signals along the way.

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Whether or not they’ve risen for the “right” reasons remains up for debate, but the upward move in interest rates has hit the usual suspects very hard in 2018, like early-cycle industries and Emerging Markets.

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Regardless of how it’s measured, the liquidity available for global stocks continues to run off.

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In recent commentaries, we’ve highlighted the surprising number of U.S. stocks making 52-week lows on both a daily and weekly basis, a sign that the market’s push higher has become more fractured. While pondering the significance of those lows, however, we missed a new 52-week high last Friday in a series we think will be especially critical to the stock market’s near-term fortunes: the 10-year U.S. Treasury bond yield. Specifically, the yield matched its weekly closing high of 3.07% posted on May 18th.

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In the past year, big-name bond gurus have put forth various yield targets that, if exceeded, would provide definitive proof that the secular bull market in Treasury bonds begun in 1981 had finally ended.

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As equity investors, we’ll readily admit to an excessive focus on the Federal Funds rate and the 10-year U.S. Treasury yield.

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Yields on 10-year Treasuries are up 10 bps since stocks peaked in January, a clear break from the behavior of prior corrections. The last four stock declines of 10%+ were self-medicating—having been accompanied by bond yield declines of 50 to 150 basis points.

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The Major Trend Index fell into its negative zone last week and we trimmed the already below-average net equity exposure in tactical accounts by a few more points, to a current 41-42%.

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At the risk of yelling “fire” in a crowded theater, we present a few parallels between recent action and the year leading up to the October 1987 crash.

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While there are many parallels between recent action and that of 1999-2000, stock market leadership is not one of them.

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Our Dow Bond Oscillator (chart) issued what looks like an increasingly prescient SELL signal on January 26th.

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The implication from VLT Momentum is that bonds are sufficiently oversold (or, equivalently, that yields are sufficiently overbought) to trigger some degree of mean reversion over the next several months.

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Sometimes we feel compelled to report findings that conflict with our outlook. And then there are the even rarer times we actually do it.

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We find it remarkable that the five-year trailing real return on Treasurys has dropped to zero without investors having (yet) suffered any real pain.

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This morning’s weaker-than-expected reading on wage inflation will no doubt boost applications to the “lower for longer” school of thought on interest rates…

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The last year has been a difficult one for any person or theme tied to the “establishment”—including mainstream Republicans, mainstream Democrats, EU commissioners and lobbyists, and, yes, even one of the established leaders of the cyclical bull market—the S&P 500 Dividend Aristocrats.

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While the next recession could be caused by a variety of factors, we suspect the recovery will eventually end like most post-war expansions, only after a significant rise in interest rates.

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On a 50-year view, stocks do indeed look cheap relative to bonds. But the inclusion of 90 earlier years of data muddies the message.

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While the Dow Jones Bond Indicator has stood the test of time, history shows that rising bond yields are not always a bearish stock market phenomenon.

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While a plunge into a recession could always result in a final “blow-off” phase to the 35-year secular bull market in bonds, any youthful, long-term buyer of 10-Year Treasurys should weigh that exciting possibility against the odds that bonds do no more than match the inflation rate over the next 30-50 years.

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The travails of active equity managers have been well-documented throughout the year, but there’s been little attention paid to the 2016 plight of economic forecasters—especially ones unlucky enough to have been accurate.

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Yields on 10-Year U.S. Treasury bonds sunk to an all-time low of 1.37% on July 5th, yet so far there’s been a mysterious absence of contrarians willing to step up to say that “the” secular low in bond yields is at hand.

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Last month we noted that European and Japanese banks were among the worst-looking industry indexes among the hundreds we monitor—and both groups obliged by dropping 15-20% in the last month.

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We’re tactically bullish, but among the twelve “Charts That Worry Us” published in the April Green Book, we’ll concede there are a few that still worry us.

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Last spring’s “Double Death Cross” in the Dow Transports and Dow Utilities had been partially reversed even before the February low, when the Dow Utilities’ 50-day moving average crossed above its 200-day moving average (thereby issuing a “Golden Cross”). The Dow Transports remain in a bear pattern based on the 50/200-day relationship, but the gap is closing fast.

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We like to think our models and indicators help us preserve a high degree of market objectivity. But sometimes we wonder: the latest rally has progressed to the point where we see trouble afoot in both the strongest and weakest charts we can find.

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Despite the improvement in market sentiment, U.S. bond yields were dragged lower by their international counterparts.

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Last month we discussed the negative market implications of May’s “Death Cross” signals in the Dow Transports and Dow Utilities.

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Our current view is the lift-off will be December or later. Assuming inflation will pick up and the Fed hikes the rate by the end of 2015, stocks will perform relatively well, with international stocks a better bet than U.S. stocks.

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The severity of the market’s current overvaluation depends on one’s historical vantage point.

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Models based on so-called relative valuations have a poor track record in practice, having misled investors at several historic inflection points. Interest rates have virtually no impact on stock market valuations, but they may have transitory effects on stocks in the short term.

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The 10-year real yield turned positive at the end of 2012 and has stayed there. We expect higher interest rates, a stronger dollar, and lower gold prices in the next twelve months.

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The recent upside breakout in the U.S. 10-year yield was successful, and it appears interest rates will remain in the new higher range for now. But what are the short-term implications of higher U.S. Treasury rates on asset allocation decisions?

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We still think interest rates are likely to be range-bound, but the range will likely shift higher to the 185-240 bps area if the current breakout is successful.

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We think interest rates will stay low for an extended period of time, so the key question is, when will rates start rising?

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Those adopting LDI today are doing so at the least opportune time in more than 60 years.

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The failed break-out to the upside on the U.S. 10-year yield fits our expectation of a range-bound but higher-volatility environment.

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Investor infatuation with portfolio income is higher than ever, just as there is less of it available than at any time in history.

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Going forward, at least in the near term, we think a good guide for the potential downside on U.S. interest rates might be the German bund yields.

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