Stocks and Long Rates
Adam Hamilton September 6, 2002 2896 Words
Living and trading through these exceedingly chaotic post-bubble times can be challenging, but there are certainly silver linings to the dark clouds of our brutal supercycle bubble bust.
My favorite silver linings are the constant opportunities to learn and grow. Just as back in the 1930s, the markets today are offering a lifetime’s worth of priceless lessons all condensed into a few short years. The speculators and investors paying attention and seeking market wisdom today are likely to be blessed with awesome knowledge and discernment that will last for an entire lifetime of playing the markets.
Many legendary traders in history dreamed of living through times such as these! We are very fortunate to be here now, regardless of the financial carnage raging around us. In light of all the excellent lessons the bust is teaching, one question that I have found perplexing lately focuses on long-term interest rates.
In history long-term interest rates have inevitably risen in highly-inflationary environments. While today’s lowballed headline government numbers like the CPI and PPI continue to hawk the magical “no inflation” fantasy, the very fountainhead of inflation behind the scenes is screaming of higher inflation dead ahead.
Inflation is a purely monetary phenomenon. General price levels rise because more currency is placed into circulation. Whenever relatively more dollars bid on relatively fewer goods and services, the result is always inflation.
The ultimate source of our fiat currency in the United States, the private Federal Reserve system, continues to flaunt enormously high monetary inflation rates. The Fed is both directly creating and indirectly allowing a literal deluge of fresh money, what economists politely obscure by calling “liquidity,” into the ailing US economy.
Incredibly, the US money supply “M” measures have just exploded in the last 12 months. M1 is up 3.2%, MZM 13.3%, M2 8.1%, and M3 8.5%. All this new money has to migrate somewhere, and obviously the US economy is limping along at growth rates an order of magnitude slower than the various M’s, so serious inflation should be bearing down on us like a runaway freight train.
If inflation is truly approaching, the ever-astute bond traders, masters of understanding the intricate mechanisms driving the US economy and inflation rates, should be selling bonds in anticipation. As bonds were sold off their prices would plunge. Since bonds have contractually-fixed payments, whenever their prices drop their yields rise.
Bond traders, when witnessing this almost unprecedented promiscuous ballooning of the US M’s, should be dumping bonds like crazy. Bond yields, especially on the long end of the curve, should be soaring in anticipation of this gargantuan inflationary wave the Fed has already pumped into the monetary pipeline.
I have been doggedly writing about this thesis for over a year now (see “Revolt of the Long Bond” and “Bond Anomalies Abound”), and so far I have been dead wrong! Longer bond yields are now at 39-year lows, plumbing abysmal depths last seen in May 1963. Why? Why are the bond players ignoring the monetary inflation? Why are long rates actually falling when the overwhelming evidence of history suggests they should be soaring?
While trying to figure out where the extreme-monetary-inflation-leads-to-high-long-rates idea is failing this time around, a mainline Wall Street adage came to mind in recent weeks.
Conventional wisdom on the Street has an almost religious zeal in assuming that the entire investing universe contains only two alternatives. Wall Street players seem to think that the only destinations for capital worth considering are US stocks and US bonds. In this fantastically simple worldview, capital can only bounce back and forth between stocks and bonds, never seeking other destinations.
Obviously this notion is seriously flawed. What about investments or speculations in gold, silver, real estate, foreign bonds, foreign stocks, futures, options, or even holding good old cash, often the ultimate bear-market “investment.” Even though there are countless other destinations for capital to slosh into, the fanciful Wall Street perception of a binary universe of only Stocks and Bonds holds tremendous sway today.
Since the vast majority of money managers are conventional thinkers and not contrarians, and these folks control enormous amounts of other people’s scarce capital, could this old dualistic idea be interfering with the expected upward trend in long interest rates?
Even the most jaded permabull these days has no choice but to admit that we are suffering through a horrific bear market. As more and more of these people grow worried, including in the professional money-manager camp, they are probably gradually evacuating the sinking US stock markets. If large amounts of capital are fleeing stocks, and its owners believe the only other worthy investment destination is bonds, could stock flight capital be bidding up bond prices and scuttling the yields?
When bond prices rise their contractually-fixed payments still remain the same. When more capital is paid for an instrument that has a static cashflow stream, the bond’s yield will drop as its price rises. A mass exodus of gargantuan quantities of flight capital from stocks into bonds could, in theory, bid up bond prices high enough to send yields plunging, regardless of underlying monetary inflation fundamentals.
As always, in order to gain more insights into this hypothesis, we built some graphs to command a broader perspective. Our graphs this week are very simple, just the S&P 500 closing price graphed under the yield on 10-Year United States Treasury Notes. The first graph has zeroed axes for a comparable-magnitude strategic overview, while the second graph zooms in for a close-up on the recent data right out of the belly of the bear-market bust beast.
I am absolutely amazed at the extreme degree of correlation and symmetry between the S&P 500 and the 10y T-Note yields in the last few years! Mathematically the two daily data series above have a correlation coefficient of 0.82, very high. Even just eyeballing the graph of the raw data adds weight to the idea that stock flight capital floods into bonds, bidding up their prices and kneecapping their yields.
The correlation is even more pronounced and evident since the ultimate S&P 500 top of 1527 on March 24th, 2000. On that very day of the climax of the greatest bull market in American history, the 10y T’s were yielding 6.2%. Since that fateful moment in market lore, the correlation between the daily S&P 500 and 10y T yield is a staggering 0.87 out of a max possible 1.00. It is no wonder the Wall Street crowd thinks stocks and bonds are Siamese twins joined at the hip!
Between the aforementioned S&P 500 supercycle top on March 24th, 2000 and September 4th, 2002, the data cutoff for this essay, the S&P 500 fell by 41.5% and 10y Treasury yields plunged by a comparable 36.0%, from 6.2% to 3.97%, today’s nearly four-decade low. The almost perfect strategic symmetry in the overall magnitude of the drops in both stocks and bond yields is stunning.
The S&P 500 Great Bear has been devouring stock investors’ scarce capital with a vengeance since early 2000, but it has thus far mercifully confined its voracious appetite to a well-established downtrend channel, marked with the blue arrows above. All the bear market plunges, bounces, and rallies have unfolded within this relatively narrow band of chart space.
On a bear market rally side note, for all you adrenaline-junkie speculators out there playing short-term stock index volatility, check out the primary bottom support line on the S&P 500 downtrend above. The late July lows, as doubted as they are today by virtually everyone, did indeed bounce solidly off the S&P 500 support line just as the two previous huge bear market rallies did. Yet one more piece of evidence suggesting this bear market rally today truly is the real thing, not just some Machiavellian strategic deception by our malevolent Ursa Major!
Back to the analysis at hand, the yellow trend lines in the graph above are not actually trend lines for the 10y Treasury yields, although they do look like it. The yellow lines are parallel to the S&P 500 downtrend and just superimposed over the 10y T data. It is amazing yet again how similar the slopes of these two downtrends are, supporting the thesis that stock market flight capital is seeking refuge in bonds and eviscerating yields.
Provocatively, the 10y T’s jumped out of this artificial trend channel constructed with the S&P 500 downslope back in late 2001. The breakout above is quite evident in the chart, soon after the post-9/11 bear market rally ignited its thrusters and lifted off from the launch pad. The 10y T yields accelerated northward shattering their former top resistance line.
This event may yet still prove to be pivotal, as the long rates appeared to finally start bucking the pressure applied to them by flight capital deserting the stock markets. The former top resistance of the 10y T yields may prove to be solid support in the coming weeks. As I pen this essay, we are right at the old resistance line just under 4% today. If it now holds as support and long yields start rising again with this current third great bear market rally, bond traders should be very wary. Rising long rates can obliterate the prices of existing bonds.
One final note on the strategic overview is in order before we get to the tactical graph. We did consider going back to the 1930s to check long rates versus stock prices in the last supercycle bubble bust in the States. We ended up nixing that idea. The problem with such a comparison is the vastly different nature of US money between the 1930s and today.
In its last great supercycle bust, the US was on a rock-solid gold standard. There was virtually zero inflation in the entire century before the First World War! This is an amazing testament to the immense power of the mighty gold standard to protect the precious savings of ordinary Americans from the predatory nature of stealthy government confiscation of private wealth through inflation. The necessities of living cost the same amount of gold dollars in the early 1900s as the did back in the early 1800s, an almost unimaginable feat today.
In a gold standard environment, as Reginald Howe’s outstanding work on long interest rates in his “Gibson’s Paradox” essays has shown, interest rates are exceedingly stable. If bond investors are confident that a dollar tomorrow will be worth as much as a dollar today in terms of real purchasing power, they will not demand high rates of return to compensate for inflation. With gold-standard paper money that truly represents a claim on real gold in a vault, volatility in interest rates is vastly lower since purchasing power is preserved.
These factors make the interest-rate environment in the 1930s virtually incomparable to the mess created today by the purely fiat US currency which lacks any true intrinsic value.
If you have both a $1 bill and a $100 bill in your wallet today, how do you know the $100 is more valuable?
In the 1930s the $100 represented 100 times more gold than the $1, so the answer was easy. Today it is much more elusive.
If you weigh each of today’s “Federal Reserve Notes” on a scale they weigh the same. It cost the Fed the same amount to physically print each bill. Each has nearly identical quantities of paper, cloth fibers, and ink. Why is your $100 bill more valuable than your $1 bill today then if they are practically physically identical?
The answer is faith.
A $100 bill today is only worth 100 times more than a $1 bill because both you and the person you pass it off to in return for real goods both have faith that it is so. If either a buyer or a seller loses faith in a pure fiat currency unbacked by anything of real intrinsic value like gold, the illusion of value will vanish in a heartbeat. Ask an Argentinean! Ultimately a fiat $1 or fiat $100 are nothing more than cleverly-printed pieces of paper, just like Monopoly money. They only work if you believe! You gotta have faith!
With the 1930s having rock-solid gold standard US dollars with undisputed intrinsic value and us today being burdened with fake toy US dollars that have no value except in an illusory widespread perception of value, there is really no way to compare the long rates in the 1930s with the long rates today.
Thanks to generations of gutless socialist politicians and American leaders who willingly destroyed the gold-backing of the US dollar to steal private wealth from hardworking Americans through inflation, the so-called “US dollar” of today is but a faint shadow of its former glorious self. History has proven that money without intrinsic and inherent value is ultimately worthless, it always fails. Gold is money, not paper. Paper is what people use to wipe their posteriors in the bathroom!
Since interest-rate environments are vastly different under solid true money, gold, and volatile play money, paper, long rates in this bubble bust are far more volatile, higher, and unstable than what was witnessed seven decades ago.
The outstanding strategic symmetry in the overall magnitude of the slide in both stocks and longer bond yields becomes even more apparent while zooming in for a tactical close-up.
Is this symmetry uncanny or what? The match between S&P 500 bear market rallies and 10y T yields is so similar that one could almost mistake an unlabeled graph of 10y T yields as the S&P 500 itself. The two series above look remarkably like keys cut for the same lock.
And unlock they do! This data could be the very keys to the mystery of the plunging long rates at a time when they should be rising due to Greenspan’s enormous fiat-money inflation. Note the graceful interplay between the blue S&P 500 and the yellow 10y T yields in the graph above. When stocks rose, bonds were sold off as capital was magnetically attracted to the bear market rallies in equities. As bond prices plunged of course, bond yields rose in concert with stock bear rallies.
Conversely, when the rampant greed on the front-end of each bear rally morphed into naked fear at the back-end, capital evacuated stocks in terror and sought out the warm comfort of the far less volatile bond markets. As money fled stocks and purchased bonds, the increased demand drove up bond prices. The higher bond prices pushed yields down, which fell lockstep with the late-stage decaying bear market rallies.
It all reminds me of those commercials on TV where all the passengers in an airplane rush to one side and their concentrated weight causes the jet to lean way over to that side. Like children’s teeter-totters on the playground, it appears over recent years the Wall Street perception of stock flight capital seeking bonds under stress was right on the money. At any signs of danger, stocks are liquidated and bonds are accumulated. Then, when the skies later appear a little clearer, capital slowly scurries back out from under the bond umbrella and tries its luck in the turbulent stock markets again.
The white arrow in the chart above marks a major anomaly, where stocks were rising but bond yields plunged. This was just the Treasury stooges in the Bush Administration trying to manipulate long rates down, as I discussed in depth last year in “Long Bond Assassinated!” Just like any attempt to manipulate markets counter to a strong trend however, this anomaly was short-lived before real market forces soon crushed it.
Also, please note the current levels of the 10y T yields. They are hovering right on their major bottom support line. Odds are, just as in the last bear market rally, they will bounce and head higher soon. If they do bounce and head northward, it will be an excellent additional confirmation that the bear market rally we are watching today truly is a major move and not merely some type of devious head-fake.
The bottom line is that the bond markets, and hence long rates, seem to be heavily influenced or even controlled by any exodus of flight capital from US stock markets corresponding with bear market rallies. Because of the extraordinary symmetry between the post-bubble bear rallies and the long interest rates, there is little doubt stock market activity is dominating capital flows into and out of the bond markets.
So far, the flight capital from stocks has overwhelmed any attempt by prudent bond investors to sell their fixed-income vehicles in response to enormously inflationary tidings in the Fed’s money-supply data. This situation probably won’t last forever though. History is unambiguous in teaching that monetary inflation inevitably leads to visible and widespread price inflation like night follows day. Indeed, monetary inflation is the true root and cause of all general inflation!
Bond investors still ought to be really careful and diligently watch for rising long rates. If bonds are sold off due to inflationary fears and long rates rise, all existing bonds become worth less as they have to compete with freshly issued higher-yielding instruments.
Rising long rates, while we haven’t seen them yet, are probably still approaching on the horizon and they will maliciously obliterate bond investors’ precious capital with as much zeal and efficiency as the Great Bear that is mauling the equity investors.
Adam Hamilton, CPA September 6, 2002 Subscribe at www.zealllc.com/subscribe.htm