There is no shortage of bond indicators at extreme readings. The 10-year note and 30-year bond both hit all-time lows in yields last week. Negative two-year yields are almost becoming routine across the globe. Not only are bonds ridiculously overpriced on a fundamental basis, but technical indicators are suggesting the rubber band is getting stretched as well. Today we will look at another bond indicator which has reached last week’s level on only one other occasion.
Bonds have been in a 30.7-year bull market. The highest yield the 30-year bond ever reached was 15.21% on October 26, 1981. The intraday low was 2.45% on July 25, 2012 and the closing low was 2.47% on July 24 & 25, 2012. So bond yields have dropped by 83.89% on a closing basis. Let’s take a look at a chart of the bond bull.
Now let’s look at the same exact chart as above except change the Y-axis to logarithmic and insert a trendline over it.
It is quite an impressive looking trendline. The r-squared is 0.91 which is extremely high for a real-world financial correlation.
Even in the context of a bull market, when bond yields got too far stretched to the downside they snapped back to the trendline.
Next we are going to look at a third chart which is a derivative of the second chart. The trendline for the second chart is the zero line for the third chart. How much the line in the second chart is above/below the trendline is the Y-axis in the third chart.
For example, on July 24, 2012 the 30-year bond was yielding 2.47% while the trendline was at 3.59%. So the 30-year bond yield was 31.4% (or 0.314) below its bull market trendline. This is the 12th most extreme reading in history. The top 11 most extreme readings for this indicator were from December 17, 2008 to January 2, 2009. The 30-year bond closing low for that cycle was 2.55% on December 18, 2008. You can see that this did not mark the all-time low in bond yields. But yields did go up 89% over the next 15.5 months to 4.84% on April 6, 2010 before resuming their downslide.
It is important to note that this indicator will eventually not work. But this will probably happen when there is a bond bear market. Bond yields will climb high and instead of snapping back to the trendline they will continue to go up. However, it is possible that the indicator becomes even more extreme than the 2008 instance.
What is interesting is all of the previous extremes in this indicator were good time to buy stocks. There have been six times when bond yields went 18% below their bull market trendline. Let’s look at how stocks performed afterward. We will use the dates of the indicator low in each cycle.
It is too early to tell how the July 2012 and December 2011 signals will turn out. But what is interesting is the other three times when bond yields were 0.21 below their trendline stocks behaved so similarly. Stocks rallied 37% to 54% for 1.34 to 1.47 years, then got hit pretty hard. If history would repeat, the S&P
would reach new all-time highs and then have a correction/bear market which would start somewhere around November 2012 to January 2013.
The beauty of this indicator is you don’t even have to believe the secular bond bull market is over. Over the past 31 years, yields have taken two steps downward, one step upward. It is possible yields will go up again and then reach even lower lows once again once the next recession/bear market hits. However, this indicator suggests stocks are the way to go over the next 16-18 months.
No positions in stocks mentioned.
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