Sunday, February 6, 2011

Something Got to Give

I watch interest rates continue to increase and the stock market indexes continue to rise. I do not believe that both can go up forever. As the old saying goes, “Something's got to give.” If I were a betting man I would say the stock markets would be the first to flinch and break. My problem is that I don’t know when this will happen. I have no doubt that it will but when is the issue. 

I was looking for a way to show you what has happened to the stock market and the bond market since the Fed said that it will have round two of quantitative easing. You do need to know how to read the chart above. The top line in Red, not my choice of color to show positive returns, is the upward movement of the S&P 500. The bottom line in black, which should be red, is an indicator of the price of the 30-year T-Bond,

The interesting thing is that if prices rise then yields fall. What is important about this chart is how the divergence has widened over the time period without any significant correction in either market. When we had a small correction in the stock market in December there was no corresponding rally in bond prices.

 As you can tell by looking at the chart the stock market is up about 15% and the bond market is off about 9%. Now let’s put both of these moves in historical context. The average return over the last 100 years in the S&P is about 8%. Over the same period of time the average return on the bond is about 5%.

 The current yield on the 30-year T-Bond is a touch under 4.75% or just over one quarter of one percent away from its historical average. The stock market on the other hand is almost 90% above the historical average. As the yield on the 30-year gets closer to 5% money will move out of either cash or stocks into bonds.

Going back to our historical numbers again, if the stock market is going to grow by 8% on average and the bond market was yielding 3.75% you might want to put more money in stocks as they may have more opportunity than bonds. If, on the other hand, the yield on the 30-year T-Bond hits 5% or even close to 5% then look for the market to run out of steam. This past week I saw an article about some money managers encouraging the Treasury to issue a 100-year bond. As long-term interest rates continue to rise look for more talk about offering bonds with maturities greater than 30 years. 

 As I said, I don’t know when the correction will happen but the stock market looks tired to me. It has to labor every day for smaller and smaller gains. So the correction, when it comes, may not be a quick sell off, but a small grind down. People who have gains will be reluctant to sell expecting the bounce off the short-term low. We could have a situation where the market grinds down slowly and then we have a blow off that take us down very quickly. 

 The greatest risk at the moment is emotional risk. The fear of not being in the market as it goes up sometimes causes investors to jump in to buy more than they would under normal circumstances. This time around buying the dips may be the wrong decision.   

Dan Perkins

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