Capital Structure Lines Blurring

The reasonable man adapts himself to the world; the unreasonable man persists in trying to adapt the world to himself. Therefore, all progress depends on the unreasonable man.
-- George Bernard Shaw

I long have had a corollary to Shaw's maxim in reference to market analysis: All analytic work worth anything is done by those who were wrong or lost, which are not the same thing. Winners, whether by dint of effort or pure dumb luck, head out to the local watering hole at the end of the day and proclaim their majesty to whomever. Blogs and Twittering are more technologically advanced ways of self-glorification, but I digress.

As a case in point, I wrote in February how realized borrowing costs, the sum of Treasury yields and option-adjusted credit spreads (OAS), had not declined sufficiently for a stock rally to begin over the next three months; this analytic technique made good sense economically and more importantly had proven its worth in the past. Six weeks later, the rally began; it was time to head back to the drawing board to see where I had been deficient.

First, instead of breaking realized borrowing costs into investment-grade and high-yield components, let's use the consolidated Merrill Lynch Corporate and High-Yield Master index. Second, instead of dividing stocks into large- and small-capitalization wings, let's use the much broader Russell 3000 index.

The chart below maps the three-month-ahead total returns on the Russell 3000 index since 1997 against the realized borrowing costs on the X-axis and the shape of the yield curve as measured by the forward rate ratio between two and 10 years on the Y-axis; this is the rate at which you can lock in borrowing for eight years starting two years from now divided by the 10-year rate itself. The more this ratio exceeds 1.00, the steeper the yield curve.

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Howard L. Simons is president of Simons Research, a strategist for Bianco Research, a trading consultant and the author of The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.

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