Higher Yields, Lower Stocks?

Negative action in Treasuries may be the catalyst for an intermediate-term correction in equities

From Standard & Poor's Equity Research

While the major stock market indexes remained rangebound last week, there was some negative action with respect to the U.S. bond market as well as bond markets overseas. The yield on the benchmark 10-year Treasury note broke to its highest level in over 20 months and may be the catalyst for the intermediate-term correction we have been calling for in stocks. Oil prices continued to base in the low $60s area.

The 10-year Treasury yield finished the week at 4.68%, the highest close since June 29, 2004. Since the latter part of January, yields on the 10-year note had been confined to a very narrow range between 4.5% and 4.6%. However, on Thursday, Mar. 2, yields broke out of this short-term trading range and continued higher on Friday. The most recent closing high for Treasury bonds occurred back on November 4, 2005, when yields topped out at 4.65%.

Since June, 2005, when yields bottomed out at 3.9%, the 10-year has been a very consistent upwardly sloping channel, tracing out a series of higher yield highs and higher yield lows. On a daily basis, momentum is positive (suggesting yields could move higher) and not yet overbought. The next piece of chart support comes in at between 4.7% and 4.9% from the congestion back in the middle of 2004. If the 10-year were to run up to the top of the channel over the next month, trendline support would come in around 4.95%.

Stepping back and looking at a weekly chart, we find that the 10-year yield has been trading sideways for some time. Since July, 2003, the yield has been mostly confined to the 3.9% to 4.7% range. There was a spike to 4.9% in June, 2004, and a spike to 3.6% in March, 2004. This is the longest period of time that the 10-year note has traded sideways since the late 1980s-early 1990s timeframe.

If the yield can move above 5%, the longer-term implications for yields would be very bearish, in our view. First, a close above 5% would break the massive base that has been building over the last three years. More importantly, though, a break above 5% would, in our view, turn the very long-term trend in yields from bullish to bearish. Yields have been falling since 1981, and have been a very definable downward sloping channel since 1987. A move over 5% would push yields out of this bullish channel and end the 25-year bull market in bonds, in our view.

Shorter-term interest rates continue their steady climb with the 3-month Treasury bill, 1-year and 2-year notes at their highest yields since early 2001. Besides Treasury rates, we are seeing yields rise across a broad spectrum. The iShares Goldman Sachs Corporate Bond ETF (LQD) has traced out a series of lower highs since June 2003. This ETF has bottomed out at around 106 three times since August, 2003. The LQD is currently just below the 106 level and is tracing out a potential, bearish descending triangle formation. A strong break below the 106 level would complete this formation and imply that prices had much further to fall. Japanese government bond prices, like U.S. bond prices, have been steadily falling since June 2005. Japanese bond prices are down about 4% in that time period. Bond prices in Canada have been falling since September, 2005.

The S&P 500, meanwhile, ignored the increase in yields late last week, and showed little movement on the week. There were attempts on Monday and Friday to punch the index to new recovery highs, but the sellers came in and the market failed. Trendline resistance for the S&P 500 comes in at 1306 and 1313, not far from current prices. Near-term chart support lies at 1280, with more important chart support down at 1255 and 1246, in our view.

Daily momentum has put in a series of lower highs since late November, and this is one of the many reasons we remain cautious on the stock market. Weekly momentum is positive, but has put in two negative divergences over the last couple of years. There is the possibility that the index is tracing out a bearish, double top formation. To complete this pattern, the recent closing low of 1255 would have to be taken out. If that were to occur, we think the index could drop to the 1200 to 1210 zone, where trendline support and chart support reside.

Market sentiment is a bit confusing of late, with some indicators persistently showing high levels of bullishness and others backing way off from their recent highs. The latest reading from Investor's Intelligence poll of newsletter writers is a prime example. The numbers showed 42.6% bulls and 30.8% bears. This compares to 60.4% bulls and 20.8% at the end of December. There has been an obvious contraction in bullish sentiment and a nice increase in bullish sentiment among newsletter writers. We saw "similar" readings to this week's numbers back in October and May, 2005, and both were associated with intermediate-term market lows.

The recent numbers are actually a little more dramatic than we saw in those two periods. Current bullish sentiment is the lowest since the week of August 27, 2004 when we had a reading of 39.6%. Bearish sentiment is the highest since the week of April 25, 2003 when bearish sentiment was 34.8%. The ratio of bulls to bears is 1.38, the lowest since a reading of 1.31 the week of August 27, 2004. Often, this contraction of bullish sentiment from one poll is confirmed by the action of many other sentiment indicators. That is currently not the case. The other investment polls are tilted towards the bull camp, while put/call ratios are also showing a bullish bent. Unfortunately, this dichotomy in sentiment is not conducive for high probability market calls, in our view.

Crude oil prices rose slightly last week, and we continue to believe the market is in the process of tracing out a base. Crude got as low as $60.30 and as high as $63.75 last week. The market has retraced over 50% of its recent correction. A 61.8% retracement, which could act as short-term resistance, would target the $64.60 level. Crude is back above its 65-day exponential moving average while daily momentum ahs turned positive. Weekly momentum is close to turning bullish, in our opinion. Recent bases put in by crude prices have tended to last a couple of months, so we think there could be some more backing and filling before the long-term uptrend resumes.


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