Cyclicality Calls for Tough Upside on S&P

I don't believe the strong correlation between the red and blue lines is a coincidence. The Federal Reserve was increasing the short-term cost of money, which makes it more difficult to make money on borrowed capital; because the cost of borrowing is higher, the profits on lent money must be higher to cover the cost.

Other factors being equal, that dynamic tends to slow lending and, consequently, economic growth. That makes stock investors a bit queasy and, at least in this cycle, has reduced the amount of money that investors want to pay for each dollar of stock-market earnings.

Now, the correlation between the yield curve and the S&P's P/E on the chart above is not perfect. Notice that the S&P's P/E (blue line) began falling before the yield curve (red line) began to fall in '04. But the yield curve began to follow the S&P's P/E down within about three months.

On the other side, in autumn '05, the S&P's P/E began to rise while the yield curve was still falling. However, once that bounce in P/E was played out, both began to trade sideways (correlating positively again) before both simultaneously moved lower into the summer of '06.

Most recently, the P/E has surged again as the stock market has rallied off its summer low. But the yield curve has not made any serious effort to follow the P/E higher over the past six months. The yield curve has remained inverted.

---

Adam Oliensis is president of Dog Dreams Unlimited, a guaranteed introducing futures brokerage, and editor of the trading service The Agile Trader. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Oliensis appreciates your feedback; click here to send him an email.