Keep Your Eye on Bond Yields
The stock market continued to rally off of the recent lows but the gains were limited, in our view, by higher Treasury yields and crude oil prices. The yield on the 10-year Treasury note bounced off the 5% zone to finish the week up near 5.2% while crude oil rallied to almost $73 per barrel. We think stock indexes have their work cut out for them with these intermarket pressures.
Looking out over the next couple of weeks, we think the bond market holds the key for stocks. The 10-year Treasury saw a very quick counter trend move that filled the gap created on June 7, down near 5%, and has quickly reversed back into its primary trend to the upside. We think the 10-year is heading for a critical test of the recent yield highs in the 5.25% to 5.30% area. At this point, we believe the support in the 5.25% zone will hold, and yields will head back down.
We think that some negative momentum divergences will develop, with respect to yields, indicating the possibility that another reversal lies ahead. In addition, sentiment towards the bond market has moved to fairly bearish levels, and from a contrarian view, this could be positive for Treasuries. Bullish sentiment towards bonds on the Consensus poll has dipped to 25% and 26% over the last two weeks, a fairly grim view for bonds. The last time we had this level of bearish sentiment was towards the end of March, 2005, and that represented an intermediate-term peak for bond yields.
The MarketVane poll is showing only 40% bulls towards bonds, the lowest since September, 2003. That also represented a time period when bond yields peaked from an intermediate-term perspective. We are also seeing fairly high levels of put/call ratios with respect to bonds, another contrarian indicator that many times has led to an intermediate-term peak in yields.
We have mentioned that we believe the long-term trend in yields is higher, with the breakout of a yield channel that goes all the way back to 1986. There have also been periods when stocks have done very well, for awhile anyway, in a rising rate environment. However, if rates rise too far, then the risk in the stock market rises exponentially. But in the short- to intermediate-term, we think yields will calm down after hitting support not far from current levels, and this could allow for another nice pop in the stock market.
So while bond yields play head games with stocks, the S&P 500 remains locked in a range between 1490 and 1540. The index has run up to minor trendline resistance, drawn off the recent closing highs, in the 1528 area. The prior highs, which represent chart resistance, sit at 1533.70 and 1539.18. On the downside, there are some shorter term moving averages in the 1513 to 1515 range with intermediate-term averages in the 1496 to 1504 zone. Key chart support, from the recent lows, comes in between 1484 and 1490. While we still think the next breakout will be to the upside, any breech of the 1490 zone should find chart and trendline support down in the 1460 area.
One way to measure market sentiment, as well as expected price volatility, leads us to the CBOE volatility index, or VIX. VIX measures market expectations of near term volatility conveyed by stock index option prices. Since volatility often signifies financial turmoil, VIX is often referred to as the "investor fear gauge". The VIX estimates expected volatility from the prices of the S&P 500 options in a wide range of strike prices. The VIX is not calculated from the Black-Scholes option pricing model; the calculation is independent of any model. The VIX uses a newly developed formula to derive expected volatility by averaging the weighted prices of out-of-the money puts and calls.
Since the VIX is based on option prices, and option prices are a function of price volatility, the VIX tends to spike when the market declines. This is because the market typically drops faster then it rises. Volatility indexes (VIX, VXO, VXN, QQV) are lagging indicators because they are based on the rapidity of price movement. In other words, they do not spike higher before prices start to head lower in a big way. However, from time to time, the action and/or relative level of the VIX is quite interesting, and can be quite telling.
Since the beginning of 2005, every pullback in the market was followed by a spike in the VIX, which is normal activity. Each spike in the VIX was then followed by a move down to the 10 area, a fairly low level on a historical basis. However, after the spike in February and March, and before the latest pullback in June, the VIX held in a higher range between about 12 and 15. Presently, the VIX is just below the 15 level so option investors are betting on a 50% greater move in the S&P 500 then they were just four months ago.
Basically, even though the S&P 500 is very close to an all-time high, and the latest pullback was a blip on the radar screen, option investors are paying higher premiums for price protection. This shows a higher degree of fear towards the stock market, and in a bull market, we think this is another positive from the sentiment side. Interestingly, the same thing happened back in early 1996, when the VIX moved to an elevated level and stayed there throughout the great market in the late 1990's.