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Indicator at 0.2% Offers Clues to Direction of Bonds, Stocks and Commodities

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If the data tells you to sell bonds, where should the money go?

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The Wall Street Journal noted the U.S. government sold the 10-year Treasury notes on Tuesday at the second lowest yield ever and the three-year auction on Monday attracted the strong bid-to-cover ratio since 1990. These extreme readings are reminiscent of the commodity froth in the spring. Are bonds the next overvalued asset class destined to go south?

Alchemyoftrading.com recently posted a weekly chart of the yield of the 30-year bond and its 52 week rate of change (ROC) from 1983 to last week. The chart made it clear that when the ROC reached low levels in the past, yields have gone higher. While the original chart focused on the indicator's predictive value towards bonds, let's see if there is any correlation to stocks and commodities as well.

We will change the chart slightly from weekly to a daily with a 252 day (i.e. still one year) rate of change and go all the way back to February 1977 when the 30-year bond was re-introduced. Because the indicator is a 1-year rate of change, it really starts in February 1978. It also must be noted that no new 30-year bonds were issued from February 14, 2002 to February 8, 2006 because the government was trying to pay off its debts. This plan did not quite work out as expected. So, in early 2006 the 30-year bond was re-introduced. Therefore, in 2002-2006 the rates in the chart aren't quite for 30-year bonds as the time to maturity slowly decreased by a few years. But it is a reasonable proxy of the long bond yield and good enough for our purposes. Anyway, let's add stocks and commodities to the mix and see what the chart looks like:


Click to enlarge

The top section is the 252 day ROC of the 30-year bond.
The second section is the 30-year bond yield.
The third section is the S&P 500.
The bottom section is the Continuous Commodities Index.

On Wednesday, December 14 the indicator closed at -36.7%. This means that the interest rate on the 30-Year bond was 36.7% below what it was a year ago. This has only happened on 20 prior days out of 8,458 trading days. That equates to the 0.2% percentile. At the top chart there is a horizontal blue line drawn at -36.7%. You can see that the 20 days where the indicator was even more extreme were congregated in two areas. These are highlighted by two vertical blue lines. One group had nine assorted dates from March 31, 1986 to April 18, 1986. The other group consisted of all 11 trading days from December 16 to December 31, 2008. Let's look at the first date from each group and see what happened next. All returns listed below use first date as the denominator.



March 31, 1986
Bond yields: The bottom was 3.5 months later -4.3%. Bond yields went up 37% in less than 19 months.
Stocks: The bottom was 0.25 months later -4.2%. Stocks went up 41% in less than 15 months.
Commodities: The bottom was 3.5 months later-5%. Commodities went up 31% in less than 27 months.

December 16, 2008
Bond yields: The bottom was 0.06 months later -11.1%. Bond yields went up 68% in less than 16 months.
Stocks: The bottom was 2.9 months later -26.8%. Stocks went up 40% in less than 16.5 months.
Commodities: The bottom was 3.5 months later -3.3%. Commodities went up 42% in less than 13 months.

Bond yields, stocks and commodities all went up at least 31%.

Since we have a sample size of only two, let's lower the standards a bit and add a third instance.

November 3, 1982
Besides the days surrounding the aforementioned groups, the next most extreme reading was November 3, 1982. The following chart is the same as before, except I've zoomed in to 1982 and added a new vertical blue line at the very, very far left of the page (almost touching the black line).


Click to enlarge

Bond yields: The bottom was 0.5 months later -3.6%. Bond yields went up 30% in 19 months.
Stocks: The bottom was 0.7 months later -6.9%. Stocks went up 20% in less than 12 months.
Commodities: No downside. Commodities went up 23% over the next 17 months.

As you can see, the moves were not as dramatic as the other instances. This is to be expected as the indicator is not as extreme as it is now. However, bond yields, stocks and commodities all went up over 20% over the next 12-19 months.

Since all three asset classes in all three instances bottomed within 3.5 months, this indicator suggests bonds yields, stocks and commodities will bottom before the end of the first quarter in 2012.

These charts suggest that one should sell bonds. So where do you put the money? This indicator suggests stocks or commodities. Which one?

It so happens that I have conveniently already addressed this question in an article called Why Stocks Will Annihilate Commodities. To be frank, the indicator in this article is diametrically opposed to my previous content which has been quite bearish on commodities. In the interest of fair and balanced reporting, I present both sides of the commodity case and leave it to the reader to decide.

On the other hand, there are no mixed signals for the long bond. And there are a lot of positives for stocks. The earnings yield for the stock market is 7.17%. The yield for the 30-year bond is 2.91%. The probability of stocks outperforming 30-year Treasury Bonds over the next 30 years is extremely high. This indicator suggests that stocks will significantly outperform long term treasuries over the next 15-19 months as well.

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No positions in stocks mentioned.
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