Research.LeutholdGroup

Even after watershed events COVID-19 and MMT, some things never change.

Next year will begin like almost every one of the past dozen years, with economists and strategists expecting bond yields to rise.

Unlike most of those years, though, there are several measures of “cyclical pressures” that would seem to give them a good chance of being right. The best-known among these might be the “Copper/Gold Ratio,” popularized by DoubleLine’s Jeffrey Gundlach, which suggests 10-Yr. Treasury yields should be around double their current level (Chart 1).

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For almost nine months, an historic Fed liquidity flood has washed away any economic, valuation, technical, or “sentimental” stock market challenges. Nonetheless, each economic disappointment brings hope this flood will intensify. Those hopes aren’t irrational, because when it comes to any measure of liquidity, rate of change is more important than level.

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Much of what we think “we know” about the bond market says yields should be headed higher.

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It would be a mistake to ignore (as most pundits will) this important forecasting tool until the next time it threatens to invert. The level and direction of the yield curve provide helpful information throughout the entire economic cycle.

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Long before policymakers’ extreme response to the COVID collapse, we feared that the Fed’s interventions were suppressing important signals from the stock and bond markets. But we now suspect that hyper-expansionary policies are suppressing price signals from the “real” economy as well.

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Turn on financial television at any random time, and you’re likely to soon hear the argument that still-high U.S. stock market valuations are “justified” by extremely-low interest rates. We’ve countered that these low U.S. rates are simply a reflection of the secular slowdown in economic and earnings growth.

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March’s mad dash for cash didn’t stop with rates/credit/FX markets. Among equities, there was also a strong preference for cash liquidity. The market rewarded companies that had strong cash positions and punished those without—which explains why traditionally defensive styles actually underperformed.

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The fear (or hope) that U.S. bond yields would fall to zero or below subsided over the last month. However, the belief that low yields merit significantly above-average P/E ratios remains stronger than ever.

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We’ve never understood investment quants’ desire to project correlations among assets. Such correlations are inherently unstable.

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As global rates have taken a precipitous dive the last few months, it’s been hard not to hum “Limbo Rock.” And just like Chubby Checker, we’ve been asking our screens “How low can you go?” on a daily basis.

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We’ve frequently written of the uncanny parallels between the rallies of 2018-19 and 1998-99, but hope that newer readers don’t mistake this analysis as a forecast.

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Many economists believe U.S. economic growth will reaccelerate in the second half, sending 10-year Treasury bond yields back above 3% late in the year. A forecasting technique with an excellent record, however, suggests the return to 3% won’t occur until late next decade!

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Corporate bonds aren’t the only asset reluctant to embrace the stock market’s latest “all clear” verdict on the 2019 economy.

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The stock market seems to have concluded that a recession will be averted in 2019, but evidence from other asset markets is less convincing.

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While investors obsess over the market level at which a hypothetical “Powell Put” might come into play (or whether such a put even exists), they seem to have overlooked the absence of another such put that proved dependable throughout the cyclical bull market.

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In September the popular claim was that “interest rates were rising for the right reasons,” and still too low to threaten stocks or U.S. economic expansion.

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We created an equity basket that can track the movement of the U.S. 10-year yield. Overall, it does a good job of capturing the major moves.

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Doubling of yields since 2016 has slammed households. Percentage increase in rates is more important than the absolute level.

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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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