Shifts in the Treasury and crude oil markets may soon provide stocks with a headwind
From Standard & Poor's Equity ResearchThe stock market continues to surprise us on the upside as the Dow Jones industrial average broke out to another new record high last week and the S&P 500 index moved to a new recovery high. Treasury yields were fairly volatile but remained near 4.5% while crude oil prices made another run above $63 per barrel.
The S&P 500 broke to new recovery highs Thursday, Dec. 14, and with Friday's gains, has run back to the top of a four-month price channel in the 1430 area. Thursday's rally followed a very tight six-day consolidation that occurred on below average volume.
Thursday's advance transpired on a pick-up in trading volume that was just above the 50-day average, and the recent pattern of volume remains positive from a short- term perspective, in our view. It indicates to us that institutions are still being more aggressive on the upside versus the downside, a clear sign of continued accumulation.
We wonder, however, if the market this month is being pushed higher to some degree by institutions that are underperforming their benchmark, and just chasing stocks higher. We will find out soon enough as the calendar turns to 2007.
We believe that since the summer, the stock market has benefited greatly from two very interrelated markets, the Treasury market and the crude oil market. It's no coincidence that that stock market has been on fire since the middle of August as Treasury yields have plummeted and crude oil prices have dropped sharply. We believe, however, that both yields and crude oil are in the process of bottoming on a intermediate-term basis and that the markets that provided stocks a tailwind will soon provide stocks with a headwind.
From the end of June until the beginning of December, 10-year Treasury yields fell from almost 5.25% to 4.4%, or almost 85 basis points. During this plunge in yields, the stock market bottomed out and then rose sharply, benefiting from the decline in yields. Since September, 2003, Treasury yields are basically flat, however, there has been a fair amount of up and down gyrations that have both helped and hurt the stock market. From September, 2003, until March, 2004, yields on the 10-year Treasury fell from 4.6% to just below 3.7%.
During the decline in yields, stocks had a very good rally with the S&P 500 running up from just below the 1000 level to the 1160 area. From May, 2004, until June, 2005, bonds also rallied, pushing yields lower and helping stocks bottom out in August 2004, and then rally for the first half of 2005.
Focusing on the 10-year Treasury, there are a couple pieces of technical evidence to suggest that the rally in bonds is ending. First, the market got very overbought, lost some momentum, and have traced out positive divergences on the daily RSI and MACD charts. Second, Treasury yields ran into substantial trendline resistance in the 4.4% zone. Third, yields are working on higher highs and higher lows. Fourth, yields appear to be working on an inverted head-and-shoulders reversal formation, with the left shoulder and head already in. And finally, the market got very oversold on a weekly basis.
Taking a look at two related charts that mimic the 10-year Treasury, we notice similar patterns. The iShares Lehman 20-year Treasury ETF (TLT) has lost some momentum over the last couple of months and appears to be tracing out a head-and-shoulders top. There have been negative divergences on the daily RSI, MACD, and money flow indicators, warning of a potential top in prices. The TLT has also run up to an area of heavy chart resistance. The continuous futures contract of 10-year Treasury prices also looks toppy. The futures contract has run to major trendline resistance that has been in place since June, 2003. Prices are very overbought on a daily and weekly basis and there have some negative divergences on the daily technicals.
Almost at the same time that yields were falling, crude oil prices also dropped sharply. In early August, crude oil topped out near $77 per barrel, and then proceeded to plunge over $21 per barrel, down to the $56 zone. However, it also appears that oil prices are tracing out an intermediate-term low, and are close to breaking out to the upside. For about the last two months, crude oil has moved sideways, tracing out what appears to be a constructive base. The daily MACD and RSI have put in multiple positive divergences after getting very oversold. The weekly technicals also moved to oversold territory. In addition, oil prices fell to long-term trendline support that has been in place since January, 2002.
During very similar times that bond yields were falling over the past couple of years, crude oil also dropped. This is not surprising as falling crude oil generally leads to falling inflation expectations. From October, 2004, to December, 2004, crude oil dropped from just above $55 per barrel to $42 per barrel. During this same time, stocks rallied nicely. The post-Katrina decline in crude oil took prices from just above $70 per barrel in August, 2005, to $57 per barrel in February, 2006 -- and to no one's surprise, the stock market rallied. The most recent drop, which we have already talked about, has also aided the stock market, in our opinion, but this may be ending shortly.
Bullish sentiment continues to build, and eventually it will be unhealthy for the stock market, in our view. However, until sentiment starts heading in the other direction -- more bearish -- we think stocks are likely to have a floor under them. The equity-only put/call ratio came in at 0.46 on Thursday, Dec. 14, one of the lowest readings of the past couple of years. The 5, 10, and 30-day equity-only ratios are all approaching areas that have marked the end of intermediate-term advances over the last couple of years.
The total CBOE put/call ratio was 0.64 on 12/14, also one of the lowest readings over the last couple of years. Both of these put/call ratios show that option investors are getting increasingly bullish, but not quite at an extreme when we look at the 5, 10, and 30-day averages.
The OEX put/call ratio, which measures what the smart money is doing, has been rising since late-November, and is at levels that have preceded intermediate-term pullbacks over the past couple of years. The 15-day exponential average of the OEX put/call ratio hit 1.63 on 12/13, one of the highest readings going all the way back to 1990.
Investor's Intelligence poll of newsletter writers is showing 59.6% bulls and 21.3% bears. This poll is at the most bullish extreme since December, 2005. The MarketVane poll is back up to 73% bulls, and that matches the highest level of positive sentiment since February, 1998.
The one conflicting investment poll of late has been the action of the American Association of Individual Investors. The AAII poll has generally seen a decrease in bullish expectations over the last four weeks with bullish sentiment dropping from 50.6% to 38.9% and bearish sentiment rising from 26.5% to 41.6%. While it is tough to say, we think this could be the start of the switch in sentiment from the bullish extreme that is so pervasive.