The Credit Crunch May Take a Further Toll

One of the more interesting aspects of investing psychology is how quickly the unthinkable becomes the normal. A year ago, $100 crude oil was still the stuff of science fiction; now it would be the end result of a very nasty selloff. Five years ago, 10-year Treasuries rose from a multidecade low of just under 3.1% in June 2003 to just over 4.5% in August 2003, when the bond market got the idea that Alan Greenspan's 1% federal funds rate was going to let inflation out of the bag.

Turn the calendar ahead five years. Even though inflation has reared its ugly head and is taunting us with the rest of its anatomy, bond yields remain trapped within that range established in the summer of 2003. Bond yields have just broken through a key retracement level at 3.937%, give or take, and have moved north of 4%.

Because a similar move over 5% last June caused momentary distress, we have to ask ourselves whether, in light of the importance of realized borrowing costs for corporations detailed here two weeks ago, the investment climate has changed for the worse.

No Fixed Relationship

First, let's take a look at the long-term relationship between stocks as measured by the S&P 500 total return index and 10-year Treasury notes. The chart below depicts their rolling three-month and one-year correlation of returns, and what is striking is the wide range these values take.

Correlation coefficients are bounded by -1.00 and 1.00; here the range extends all the way from -0.80 to 0.80. That's an exceptionally wide range of values for two markets that have a common factor between them: long-term interest rates. This should tell us right away that a single-equation model of stocks' fair value based on interest rates is dangerous nonsense at best.

Stock/Bond Relationship: Comparison With October 2002

Click here for larger image.

In addition, please note how the correlation regime changed once the Asian crisis, now being reprised on a smaller scale in Vietnam, came on the scene in the fall of 1997. The Federal Reserve shifted into a risk-management mode from which it has yet to emerge; it has elected to fight every financial downturn with serial bubble inflation. A dotted black trend-line highlights this change.

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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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