Bond, Treasury Bond
Not quite the catchy moniker that James Bond uses and attractive double agents don't swoon when they hear it but it still controls our fate. As much as I hate to keep writing about it I hate more watching the markets tick up or down in lock step with changes in the bond market. That was exactly what happened this week with the closing rebound on Friday only coming after the bond market closed.
Dow Chart - Daily
Nasdaq Chart - Daily
S&P Chart - Daily
Wilshire 5000 Chart - Daily
It has been a pattern all week with the market making major moves after the bond market closed and the perceived danger passed. I am going to try and explain the problem with pictures and I promise I will be brief. The yields on bonds have gone from abnormally low levels to abnormally high levels and it caught the stock market off guard just like it caught bond traders off guard. While everyone was pleased to see yields fall this week after the three day bond auction they did not drop far. They also did not drop below support at 4.20%. The stock market watched the yields with a nervous twitch all day Friday to see if the panic selling in bonds was over. The yield rise into the close was disturbing but the Dow managed to close with a +30 point spurt on short covering and possible Saddam speculation.
10-year Treasury Yields - 60 min
While the markets were pleased to see the drop from the 4.95% high on August 1st the drop to 4.28% on Friday was really just an oversold correction and not meaningful in the long term scheme. The chart below shows how minor the drop was this week.
10-year Treasury Yields - Daily
Why do we care what is happening in the bond market? Because the bond market yields impact the economy and stocks and they are permanently linked. I will get to the details in a minute but suffice to say if yields go down (bonds up) the economy benefits and the market rises. Conversely if yields go up the economy suffers and the market falls. This chart shows the relationship between the S&P (red) and 10-year yield (black). Note the basic divergence in March and April and then the extreme divergence in June. In June the extremes in yield lows and market highs were abnormal. Now that yields have risen and do not appear to be falling the natural tendency would be for the S&P to revert back to the historical divergence and move to a lower level.
10-year Treasury Yields/S&P - Daily
Now that I have totally bored you I will try and wrap this up quickly. The market direction is locked to the bond yields because the cost of borrowing affects everything we do. Costs for new equipment, inventory, office buildings, computers and home mortgages all depend on rates. Every quarter point has an impact as we have seen from Fed rate changes over the years. We have had the equivalent of four 25-point rate hikes over the last six weeks. This is far faster than the Fed has acted in recent memory. Image the carnage in the market if the Fed had announced a surprise 25 point rate hike four times in the last six weeks. The Dow would be trading at 8000 instead of 9000. Now I ask you, what is the difference? The rates still changed and the market has not yet reacted. It is as if the market is hoping to wake up on Monday and find out it was just a nightmare. Don't hold your breath.
According to bond junkies this has been the worst quarter for bonds since 1987 and we all know what happened then. While the conditions are considerably different in 2003 the damage may take some time to work out of the system. Traders simply do not know what to expect. Everyone is looking at everyone else for direction.
While indecision is running rampant there is a stealth bear market in techs hiding behind the major indexes. The Nasdaq has traded down five of the last six days and lost -71 points for the week. Why you ask? First because the techs were up as much as 50% since the lows and funds eager to show gains and unsure of the future are locking in profits. In any bull move and especially one as strong as we have had there is normally a 10% correction or better when the move runs out of steam. It appears the Nasdaq is feeling this pain especially after Cisco failed to encourage investors.
Secondly there may still be some potholes in the recovery road. Taiwan Semiconductor reported a revenue decline due to seasonal inventory adjustments by its customers. Not a big deal but any decline in revenue is cause for concern by investors today. NVDA warned that sales for the next quarter would be less than expected and gross margins were shrinking. NVDA is a big customer of TSM and that drove TSM even lower. UMC reported a 40% drop in earnings for the 2Q and said it expects 3Q shipments to drop 10%. These concerns drove the SOX to an -11.84 loss for the day and a four-week low. The SOX is still very extended from its 260 low in February and a +57% gain to the July high of 408. It is already -10% off its high with support in the 360 range.
SOX Chart - Daily
Also discouraging is the Russell-2000, which has dropped -28 points from its July highs and is still some distance from support at 440. The Russell is the best indicator of fund direction. When conditions are seen to be improving funds venture away from large cap safety and into the small cap market where the really large gains can be made if they pick a winner. If they see weakness ahead they abandon the small caps and run back to big cap liquidity and perceived safety. This week we saw small caps and techs drop and the Dow rise as money flowed back into the safety of cyclical big caps.
Russell-2000 Chart - Daily
Cluttering the field of vision is the global outlook. Italy announced it was in recession for the first time in eleven years on Friday. Not that Italy is a huge world economy but it is another domino in the economic chain. According to the chip companies Asia has not recovered completely from SARS yet. Oil prices continue to hover at $32 a barrel with no relief in sight. No earthshaking problems but still smoke on the horizon.
Next week we have to deal with a Fed meeting on Tuesday. We are expecting nothing out of the Fed meeting except a rewording of the last policy statement which was a rewording of the last statement before that. The Fed funds futures are showing a zero chance of a rate cut. There is a good possibility retail traders will still buy the rumor in hopes of a surprise. The Fed has repeatedly said they are very accommodative and do not think another cut is needed. The wild card here is the bond yields. Greenspan has got to be wringing his hands over the spike in rates just when he was promising to keep rates low for the duration of his term. He has to weigh the potential risk to the stock market with the need to do/say something to scare the bond market. Should they decide to say something deflationary (sorry, unwelcome disinflation) they could knock bond yields back into June but it could create a stock market panic. Now, do they want to risk the market falling under the weight of rising yields along with the economy OR give bonds a swift kick and then prop up the market with some fedspeak the following week? The multitude of possibilities is dizzying.
Next week starts out slow economically with nothing on Monday and only the FOMC meeting on Tuesday. The rest of the week is packed full of reports but after the Fed statement they may not matter. You do not want to hear this but with earnings over gentlemen prefer bonds. I know, it is a corny line but it is the truth. They will watch the bonds more than the economics next week. Conservative pension funds typically switch from stocks to bonds when the yields reach 4.50%. We saw some of those asset allocation programs early this week. We closed on Friday at 4.28% and not very far away from the magic number. We also have $60 billion in new supply on bond dealers books and they will be trying to dump that off to the end buyers. This will also depress cash flow available for stocks.
Last Sunday I mentioned the potential for a roller coaster ride and this week certainly followed through on that prediction. The high for the week was 9209 and the low 8997 with plenty of spikes and dips in the middle. The coming week should not change. I expect more of the same as we continue to test the highs and the lows of our trading range. We have been locked in the 9000-9300 range since July 1st and have resisted all attempts to trade lower despite historical precedent. The longer we stay in this range the better the chance of a very strong and lasting move when we break out. Unfortunately that break could go either way. If the economics continue to line up positively then the longer we stay in this area the better chance of an upside break. The Dow closed right in the middle of the range on Friday and is in neutral territory. The Nasdaq, Russell and SOX are not so safe and could test their support levels early next week. With INTC, MSFT, ORCL, DELL, QCOM and SUNW all threatening to break support I would say it was a safe bet but Fed meetings have a funny way of impacting the market. Check out the declining new highs and increasing new lows in the statistics header of this commentary. Keep those seatbelts fastened, this roller coaster has plenty of ride left.
Enter Very Passively, Exit Very Aggressively!