STOCKS TOOK OFF IN 1951 AFTER THE FED LET
BOND YIELDS RISE -- THEY MAY HAVE TO DO THE
SAME AGAIN -- THIRTY YEAR BULL MARKET IN
BONDS MAY BE COMING TO AN END -- THAT
SHOULD HELP STOCKS -- NASDAQ/BOND RATIO
MAY BE BOTTOMING -- BANK AND HOMEBUILDING
ETFS ARE CHALLENGING THEIR 2010 HIGHS AND
SHOW NEW MARKET LEADERSHIP
By John Murphy
FED BOND INTERVENTION DURING 1940S CAPPED STOCK PRICES... I
wrote last Thursday why the Fed's current policy of buying longer-dated maturities to
keep bond yields from rising may actually be putting a cap on stock prices. I explained
that the last time the Fed did that was between 1942 and 1951 in order to keep wartime
inflation from pushing bond yields higher and to help pay wartime debt with lower rates.
I also mentioned that it wasn't until 1951 that the Fed finally stopped intervening in the
bond market which allowed bond yields to rise and bond prices to fall. That action helped
launch a two-decade bull market in stocks. Chart 1 shows the 30-Year T-Bond
Yield staying relatively between 1942 and 1950 which was largely due to the Fed policy.
The red circle shows bond yields breaking out to the upside during 1951 when the Fed got
out of the way. The resulting jump in bond yields caused bond prices to fall which caused
a huge rotation into stocks. Chart 2 shows the Dow Industrials in a large bottoming
formation between 1932 and 1950. The blue circle shows the Dow finally breaking
through the 200 barrier for the first time in twenty years. That upside breakout in the
Dow took place in 1951 which coincided with the upside breakout in bond yields.
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Chart 1
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Chart 2
BOND YIELDS AND STOCKS ROSE TOGETHER AFTER 1951... Chart 3 plots the
two markets together between 1942 and 1969. The two upside breakouts took place at the
same time during 1951 (see circles). Bond yields and stocks rose together from that point
until the late 1960s. The reasoning is relatively simple. When the Fed allowed bond yieds
to rise after 1951, yields rose to keep pace with a strengthening postwar economy. Rising
bond yields produce lower bond prices. It was most likely the drop in bond prices that
forced investors to sell bonds and buy stocks, which they did for the next two decades.
That's an example of how Fed intervention in the bond market prevents bond prices from
falling, which prevents the normal rotation out of bonds and into stocks near the end of a
deflationary era. In other words, Fed intervention in the bond market actually capped
stock prices during the 1940s. It may be doing the same thing now.
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Chart 3
THIRTY YEAR BULL MARKET IN BONDS... Chart 4 shows the trend of the bond
market since 1980. After the inflationary 1970s ended, bond yields peaked in 1981 and
have fallen for the thirty years since then. During those thirty years, the yield on the long
bond fell from 15% to below 3%. That has produced a thirty year bull market in bond
prices (solid matter). [Bond prices rise when yields fall]. After thirty years, it would be
normal to expect that trend to start reversing. That would result in higher yields and
lower bond prices. That can only happen, however, when the Fed stops intervening to
keep bond yields artificially low. In so doing, the Fed is encouraging investors to stay in
Treasury Bonds too long. That's preventing a rotation out of bonds and into stocks which
normally takes place near the end of a deflationary period (just as it did during the
1940s).
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Chart 4
BONDS HAVE OUTPERFORMED STOCKS SINCE 2000... Chart 6 is a "ratio" of
the S&P 500 divided by the price of the 30-Year Treasury Bond. Stocks did better
than bonds between 1980 and 2000. Since 2000, however, bonds have been the stronger
asset. In my view, that's because of the emergence of deflation over the last decade, which
hadn't happened since the 1930s. [The emergence of deflation since 2000 is one of the
reasons that Mr. Bernanke has resorted to tactics last used during that earlier era]. Two
major stock market declines starting in 2000 and 2007 caused the stock/bond ratio to
fall sharply (down arrows). Market upturns during 2003 and 2009 caused the ratio to
rise. It's still rising. Chart 6 shows a huge descending price channel on the ratio since
2000. The ratio would have to break through the upper resistance line to signal a major
shift back to stocks. But it may not be too soon to start preparing for that eventuality.
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Chart 5
NASDAQ/BOND RATIO MAY BE BOTTOMING... My Tuesday message showed the
Nasdaq Composite Index trading at the highest level in 12 years. I mentioned in that
message that it was the plunge in that technology-dominated index during 2000 that
started the "lost decade" for stocks and a strong decade for bonds. I also mentioned that
the recent upside breakout in the Nasdaq may be signalling that the long-term outlook for
stocks is improving.. Chart 7 plots aratio of the Nasdaq Composite Index divided by
the 30-Year Treasury bond price. The ratio peaked in 2000 (yellow circle) when
stocks collapsed and bond prices soared. The ratio has trended sideways since then
between its 2002 low and its 2007 high. It bounced off its 2002 low during 2009 (blue
circles), and has risen since then. The Nasdaq/bond ratio is now moving up toward the
upper end of its decade-long trading range. If it's able to exceed its 2007 peak, that would
be a strong sign that the long-term pendulum has swung away from bonds and back to
stocks. That may not happen, however, until the Fed stops keeping bond prices artificially
high, and allows a normal rotation out of bonds and into stocks to take place. Mr.
Bernanke is a student of the deflationary 1930s. I hope he's also a student of what
happened during the 1940 and 1950s, and the decades after that.
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Chart 6
BANKS ARE FINALLY SHOWING IMPROVEMENT... Another reason that I'm
turning more optimistic on the stock market's long-term outlook is the improvement
being shown by banks. In past market up cycles, financial stocks have been market
leaders. That hasn't been the case for most of the last decade, and especially since 2007.
The green bars in Chart 7 show thePHLX Banking Index (BKX) plunging between
2007 and 2009 which acted as a tremendous weight on the S&P 500 (solid line). The
BKX fell to the lowest level in more than a decade. For the first time in a long time, banks
are actually starting to show market leadership. The S&P 500 has been locked in a
sideways trading range between its 2000/2007 highs and its 2002/2009 lows. A recovery
in banks (and other financial stocks) could go a long way in pushing the S&P 500 back to
the top of its long-term trading range. It would have to clear its 2007 high, however, to
signal that major new up cycle has begun.
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Chart 7
SO ARE HOMEBUILDERS... The monthly bars in Chart 8 show the trend of the Dow
Jones US Home Construction Index since 2000. Three distinct trends are shown.
The first is the uptrend between 2000 and 2005; the second is the downtrend between
2006 and 2009 ( (see trendlines). Since 2009, however, the home-building index has
been moving sideways in a possible bottoming formation. It has just broken a down
trendline extending back to its 2005 top (see circle), and is moving up to challenge its
2010 high. A close above that chart barrier would turn the current sideways trend into a
new uptrend. That would be bullish for housing stocks and, in my opinion, the market as
a whole. The solid line is the S&P 500 which is shown for comparison purposes. The
rally in housing stocks between 2000 and 2005 helped cushion that earlier market
decline, and helped stabilize the market between 2003 and 2007. The 2007/2008 plunge
did just the opposite. It seems logical to assume that the new upside leadership in
homebuilders is an early sign that the housing industry is finally showing signs of
improvement. That should be good to the stock market.
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Chart 8
BANKING AND HOUSING ETFS TEST 2010 HIGHS... Chart 9 shows the Dow
Jones US Home Construction iShares (ITB) in the process of challenging its 2010
high. While that chart barrier may produce some short-term profit-taking, an eventual
close above that level would be a very bullish sign for homebuilding stocks. The solid
matter in Chart 9 is a ratio of the ITB divided by the S&P 500. You can see that relative
strength measure turning up during the fourth quarter and showing market leadership
since then. The same is true for regional banks. Chart 10 shows the KBW Regional
Banking SPDR (KRE) also challenging its 2010 high. Its relative strength ratio (solid
matter) also turned up during the fourth quarter. There again, some short-term profittaking is likely. An eventual upside breakout, however, would be a very positive sign for
the banking sector and the stock market. It's also worth noting that both charts look
remarkably similar. That shouldn't be much of a surprise since banks and housing are so
closely aligned (banks lend mortgages). The Stockcharts Technical Ranking System
(SCTRS) ranks homebuilders as the top market ETF (99.9) and regional banks second
(99.5). That's got to be a sign that things are starting to get better.
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Chart 9
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