Stock/Bond Ratio Projects Exciting Times Ahead

Are stocks ripe for a deeper correction or is the 5%+ January hiccup – the biggest in well over a year – already in the rearview mirror? The stock/bond ratio provides a dimension not often considered.

The S&P 500 (SNP: ^GSPC) just had its first 5%+ correction in well over a year.

Some say that’s bullish, because it brought prices down to levels that spark new buying. Others point to a potentially bearish technical breakdown at a time when stocks are over-loved, over-valued, and over-hyped.

Which one is true?

As the old saying goes, there are always three sides to an argument: His, hers and the truth.

The stock/bond ratio provides another dimension to this ‘argument.’

We use the SPDR S&P 500 ETF (NYSEArca: SPY) as proxy for stocks and the iShares 7-10 Year Treasury Bond ETF (NYSEArca: IEF) as proxy for bonds.

The S&P 500 ETF – SPY/IEF ratio chart below shows the SPY/IEF ratio vacillating between support and resistance.

The SPY/IEF ratio rises when the S&P 500 moves higher and bonds move lower.

A spike in the SPY/IEF ratio accompanied every S&P 500 high. This includes the most recent January high.

However, the SPY/IEF ratio did not touch resistance at the most recent high. It also didn’t touch support at the most recent low.

Nothing says that resistance or support need to be met, but often such support/resistance levels act as magnets.

If the SPY/IEF ratio is still in need of touching both support and resistance levels, as a result, we conclude that the January high didn’t mark a major top and last week’s low didn’t mark the end of this correction.

Obviously, this would translate into exciting times ahead.

A detailed forecast for the S&P 500 is provided here:

S&P 500 Forecast: Short-Term Gains vs Long-Term Pain

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

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S&P 500/Bond Ratio Shows Stocks are Overvalued

Much has been written about the ‘great rotation’ from bonds into stocks. In reality, investors ask themselves every day if there’s more value in stocks or bonds. There’s one accurate measure to determine where’s more value.

Stocks or bonds? Essentially that’s a decision investors make every day.

As with pretty much every other purchase, investors want to get the biggest bang for their buck and avoid risk. In other words, risk/reward is key.

What’s the better risk/reward play right now? Stocks or bonds?

To find out we will take a look at the value of the S&P 500 Index relative to 10-year Treasury prices. The iShares 7-10 Year Treasury Bond ETF (NYSEArca: IEF) is used as proxy for 10-year Treasuries.

The chart below plots the S&P 500 Index against a ratio attained by dividing the S&P 500 against the price of IEF (S&P 500:IEF).

This is one of the easiest and most effective ways to determine the value of both asset classes relative to each other.

The chart shows that S&P 500:IEF ratio extremes put the kibosh on stocks every time. The degree of the correction varied, but the direction for the S&P 500 was the same every time – down.

There is one problem though.

It usually takes hindsight to determine what constitutes an S&P 500:IEF ratio extreme.

The ratio, although extreme right now, could become more stretched. Will it?

The dashed horizontal gray line shows today’s ratio in correlation to prior readings. In fact, the ratio is at a point where it turned down in early 2007 and early 2008. This appears as natural resistance for the ratio … and the S&P 500.

The S&P 500:IEF ratio suggests that risk is increasing for the S&P 500.

This harmonizes with the S&P 500 chart, which conveys the message that stocks are at a short-term inflection point. This article highlights some technical ‘speed bumps’ most investors aren’t aware of: What’s Next For the S&P 500?

 

New York Fed Research Reveals That FOMC Drove S&P 55% Above Fair Value

Why do stocks typically outperform short-term government bonds? It’s a question of risk and reward. Brand new research from the New York Fed shows that the Federal Open Market Committee (FOMC) is the cause for a 55% overvaluation of the S&P 500.

Conspiracy theories are fun, but unfortunately they are often just that – theories – grown on the fertile soil of biased bloggers, journalists, or conspiracy groups.

Here’s a super enlightening piece of research published right on the website of the Federal Reserve Bank of New York. It comes straight from the horses mouth so to speak and tackles a very controversial subject.

The Fed – Stuck with the Hot Potato

The research talks about the equity premium. The equity premium is usually measured as the difference between the average return of the stock market and the yield on short-term government bonds (corresponding ETF: iShares Barclays 1-3 Year Treasury Bond ETF, SHY).

Analysts agree that the return of stocks should be greater than that of bonds to compensate for the volatility of stocks.

However, analysts can’t agree on the reason why the return of stocks is greater than that of short-term government bonds and what the return margin between stocks and government bonds should be to compensate for the extra risk linked to owning stocks.

This disagreement has given birth to the term “equity premium puzzle.”

David Lucca and Emanuel Moench (research posted on the New York Fed’s website) prove that: “80 percent of the equity premium on U.S. stocks has been earned over the twenty-four hours preceding scheduled Federal Open Market Committee (FOMC) announcements.” The researchers call this phenomenon a “drift.”

More than just a Drift

The pre-FOMC announcement drift is best summarized by the chart below, which provides two main takeaways:

– Since 1994, there has been a large and statistically significant excess return on equities on days of scheduled FOMC
announcements.

– This return is earned ahead of the announcement, so it is not related to the immediate realization of monetary policy actions.

The chart shows average cumulative returns on the S&P 500 stock market index (related ETF: S&P 500 SDRS – SPY) over different three-day windows.

The solid black line (the chart is not as clear as it should be, but it’s taken directly from Lucca and Moench’s research) displays the average cumulative return starting at the market’s opening on the day before each scheduled FOMC announcement to the market’s close on the day after each announcement.

The dashed black line (at the bottom), which represents the average cumulative return over all other three-day windows, shows that returns hover around zero.

This implies that since 1994, returns are essentially flat if the three-day windows around scheduled FOMC announcement days are excluded. What does that mean?

The 55% FOMC Overvaluation

Let’s take a look at another chart to visualize the effect of the pre-FOMC announcement spike.

The chart below shows the S&P 500 (SPY) in blue and red. The blue line is the actual S&P 500 performance, the red line (that’s where it gets interesting) is where the S&P would be if you exclude the returns on all 2 pm – 2 pm windows ahead of the FOMC announcement.

Excluding those returns the S&P would trade around 600, 55% below current prices.

Surprising Conclusion

The conclusion – after seeing the evidence Lucca and Moench have kindly provided – seems pretty obvious. But perhaps more surprising than the actual research itself is the ending statement of Lucca and Moench’s analysis: “The drift remains a puzzle.”

The original article published on the New York Fed’s website can be found here.

Federal Reserve and ECB Spent $3.5 Trillion, But Economy Remains Flat

There’s much talk about QE3. What would QE3 do for stocks and the economy? Since 2007 the Federal Reserve and European Central Bank (ECB) spent about $3.5 trillion on various stimulus packages. This has kept the S&P 500 afloat while economic activity is deteriorating.

I was going to start this article out with a bunch of sobering stats … but decided to go with a cartoon instead. A few pen strokes by a capable artist may explain the situation better than an avalanche of numbers. Here it is:

We are all familiar with the term “house of cards” and its implication. For illustration purposes, let’s assume we’re dealing with a number of card houses. What’s curious is that most of them are falling apart while one of them is still standing.

This house of cards is not separated from the others or protected by a draft, but it keeps standing as if it’s best buds with a glue gun.

It’s The Glue Gun

It’s amazing what can be fixed with a glue gun. My wife’s favorite “household appliance” is her trusted glue gun. It comes out whenever something’s on the fritz or “beyond fritzed.”

My wife isn’t the only one to like her glue gun, central banks around the world, particularly the Federal Reserve and European Central Bank (ECB), love their (glue) guns and they’re sticking to them.

In fact, their glue gun – printing money – has become a sort of addiction. Without “sniffing glue,” the economies just can’t survive.  How do we know that?

Now would be a good time to pull out some charts and data. The chart below compares the performance of the S&P 500 (SPY) with economic activity and the balance sheets of the Federal Reserve and ECB.

Rather than listing economic activity individually, the chart shows the Weekly Leading Index (WLI) published by the Economic Cycle Research Institute (ECRI).

The ECRI WLI is a proprietary index that combines multiple data points including unemployment, CPI, PPI, mortgage applications, etc.

The chart is almost self-explanatory, but let’s just highlight the obvious anomalies.

The S&P has been going up (green arrow). The ECRI WLI – meaning broad economic activity – has been going down. Why?

The balance sheets (glue guns) of the Federal Reserve and ECB glued the system together when it was falling apart. The ECB’s liabilities are close to $4 trillion, the Federal Reserves’ about $2.6 trillion.

The stock market thus far is enamored by the glue gun approach, but the economy’s saying that the glue gun isn’t working. Something’s gotta give. I think it will be the stock market.

Silver is Getting Ready to Break Out

January 2011. That’s when silver prices started carving out a massive descending triangle.

A descending triangle has a horizontal lower boundary line (called demand line) and a down-sloping upper boundary line (called supply line).

The implication of a descending triangle is generally bearish.  Several ancillary components will either increase or decrease confidence in the reliability of the pattern.

Decreasing volume before the breakout and increasing volume accompanying the breakout increase confidence. Trading volume for silver futures has been on the decline, an indication that the pattern will work out.

However, good reliable breakouts from a descending triangle usually occur at about the same stage of pattern completion as they do in symmetrical triangles. The earlier the breakout the less apt it is to be a false move.

In the case of silver (chart below), prices are squeezing right out to the apex without any breakout yet. This increases the odds of the triangle breakout failure.

What makes silver’s triangle more intriguing is the smaller triangle within the larger triangle. And wait … there is more: If you chart the iShares Silver Trust (SLV) you will note that prices already fell and climbed back above the lower support line.

Supplementing Technicals

I like looking at technicals, but have found that it takes more than a one-dimensional analysis to identify high probability trading opportunities.

The bottom of the chart shows the net short positions of commercial silver futures traders. Commercial traders include silver producers who use futures to sell future production. Because they are active in the business they are considered the “smart money.”

The latest Commitment of Traders (COT) report shows that the smart money is less short now than at previous silver bottoms. From a sentiment point of view, that’s bullish for silver.

Summary

Silver’s performance often sets the tone for U.S. stocks and major indexes like the S&P (SPY), Dow (DJI) and Nasdaq (QQQ), so what silver does here might provide valuable clues for investors of all sorts.

The silver market thinks the lower trend line at 26 is important, otherwise it wouldn’t have touched it several times. If the market thinks so, we should too.

Incidentally, gold prices and the SPDR Gold Shares (GLD) are also sitting atop important support. After an extended period of sideways trading, it seems like we’re getting ready to see some fireworks.

The Profit Radar Report will try to identify how to best take advantage of big moves.

30 Year Treasuries – Is a Major Market Top Imminent?

A look at yields shows that investors consider U.S. Treasuries one of the safest asset classes in the world. This alone is reason for concern, but there’s more.

Bill Gross, the world’s most respected bond manager, started a crusade against long-term U.S. Treasuries early 2011. 30-year Treasuries are up about 25% since then. Why?

In a world of flux and flash crashes U.S. Treasuries are still considered a save haven. That save haven comes at a price (or lack of yield). On June 1, 2012, Treasury yields dropped to an all-time low.

For 30-year Treasuries that’s a 35-year low (30-year Treasuries started trading in 1977. For 10-year Treasuries that’s a 200+ year low. According to Bianco Research, the 10-year T-note has reconstructed data going back to the early 1800s.

The euro problems won’t magically disappear anytime soon and conventional wisdom suggests investors will continue to flock towards U.S. Treasuries. But conventional wisdom is not always right and there are a number of logical contrarian arguments to suggest a major market top is forming instead.

Running into Resistance

The chart below plots the S&P 500 against 30-year Treasuries since 1988 (that as far back as my data goes). The red lines are technical chart resistance slightly above current prices.

On June 1, those two trend lines were at 153’11 – 153’19. The June 4 high for 30-year Treasury futures was at 152’19. Since then prices have peeled away slightly but haven’t closed below 148. It is possible that a major top is already in place, but it’s also possible that the two trend lines (will be at 154 – 155 in August) will be tested more deliberately.

A new high for Treasuries would make sense if stocks have enough fuel for another rally. What if stocks fall? Shouldn’t Treasury prices move up?

Since we’re discussing the topping of a major market top for Treasuries, the chart below highlight how stocks performed every time Treasuries dropped significantly. Stocks are usually up.

The up side potential for stocks right now however is limited, so something major would have to change for stocks and bonds to move down at the same time. What could that be?

Deflation

Let’s take a look at the entire U.S. bond market, including corporate and junk bonds. The interest paid on bonds is directly correlated to the bond issuers credit worthiness. The current low-yield environment implies good credit worthiness and low rates of default.

This however will change if the amount of defaults or the risk of default increases. The countries of Greece, Spain, Portugal, Italy, etc. have generously provided a window into the future for the U.S. bond landscape.

What starts out with a flight to security turns into the fear of losing principle once bond holders see bond issuers in trouble and defaulting. Bond holders will sell their bonds, thus driving down prices. Bond issues will have to pay higher interest rates to attract new buyers. A down ward spiral is born.

The U.S. government is not at risk of default (at least not yet). No doubt Treasuries will perform better in such an environment as junk bonds and most corporate bonds. Although the spread between low quality bonds and Treasuries will increase, the yield for Treasuries will still have to go up and prices will have to go down.

There are no certainties in investing, but I think there’s a very highly probability of the above scenario playing out eventually. When? That’s where it gets tricky. The fundamental circumstances for deflation to take over are in place, but the Fed has been able to hold back the deflationary winds of fury.

Either another test of resistance for Treasuries or a break below support will be a good starting point to identify a high probability profit opportunity.

The Profit Radar Report will identify when this profit opportunity is ripe for plucking.

Long-term Treasury related ETFs include the iShares Barclays 20+ Treasury ETF (TLT), Short 20+ Year Treasury ProShares (TBF), UltraShort 20+ Year ProShares (TBT)