Early Signposts Pointed to Monday's Rally

Those hoping Friday's midday reversal was a significant development got a major boost today as stock proxies rallied solidly, accompanied by healthy market internals.

The Dow Jones Industrial Average rose 2.2%, the S&P 500 gained 2.8% and the Nasdaq Composite climbed 3.2%. In New York Stock Exchange trading, advancers bested declining stocks by 3 to 1 while up volume totaled a healthy 88.5% of the 1.2 billion shares traded. In over-the-counter activity, gainers led by 2 to 1 while up volume was 76% of the 1.35 billion shares exchanged.

Whether it was the resignation of Qwest Communications (Q Quote) CEO Joseph Nacchio or the more overtly positive upping of second-quarter guidance by McDonald's (MCD Quote), investors reacted positively to seemingly every bit of news.

The irony of today's rally is that it occurred on a day when San Francisco Fed President Robert Parry said the recent declines in equities have raised uncertainties about the path of consumer spending. Furthermore, on a day when The Wall Street Journal featured a page one story about the strength of so-called average stocks, past leaders and one-time momentum favorites were leaders today. The Nasdaq 100 rose 3.6%, while the Amex Biotech Index jumped 5.8% and the SOX gained 5.4%.

The push into equities aided the dollar, which posted modest gains vs. the euro and yen, while gold slid 0.5% to $318.10 per ounce and related shares fell in concert; the XAU lost 4.3%. Meanwhile, the Treasury market tumbled as the price of the benchmark 10-year note lost 13/32 to 100 5/32, its yield rising to 4.85%.

All About Bonds

On June 7, this column detailed a report by Bianco Research that forecast a near-term pullback in inflationary indicators, including the spread between yields on Treasury inflation protected securities (TIPS) and the 10-year note, the Bridge/CRB Index, inflation-sensitive equities, the dollar vs. the euro, crude oil and spot gold.

Putting that forecast together with an expectation for a near-term improvement in the dollar, I surmised the following: "If inflation fears recede, the 10-year yield could fall below 5%, and that seems consistent with an improving dollar, weakening gold prices and, yes, a rebound in the stock market in the days and weeks ahead."

Last week was not a particularly bullish one for stocks, but one that saw many of the other factors fall into place, including the 10-year Treasury yield falling below 5%, aided by a weaker-than-expected PPI report and other signs of moderation in the economy's rebound. Also, the dollar stabilized while the price of gold fell about $8 per ounce last week, helping set the stage for today's rally, during which those trends continued.

Actually, today's rally was forecast on Friday, and not necessarily by the equity market's midday rebound. Rather, the combination of the S&P 500 futures big preopen decline and big rally in the 10-year Treasury note futures was the key sign, according to a report today by Bianco Research.

Prior to Friday, there had only been 15 occasions since Oct. 19, 1987 when S&P 500 futures opened at least 10 points below their previous day's close while 10-year Treasury futures opened higher by at least 12 ticks (which is 1/32 of a point).

Bianco Research deduced that such extreme moves in Treasury futures occur when "bonds are reacting to stocks." Prior to Friday, the firm noted, S&P futures opened lower by 10 points or more 88 times since 1987 but Treasury futures opened higher by at least 12 ticks only 15 times.

"When bonds get so 'excited' that stocks are going to plunge, and rally before stocks open, it usually occurs near, or on, a major low in stocks," the report surmised. Three months after the prior 15 occurrences, the S&P 500 has posted average gains of 8.5%, with only two periods of negative returns, Bianco reported.

On Friday, S&P futures opened down 14.80 from the prior day's close while 10-year Treasury futures opened higher by about 15 ticks, producing only the sixteenth combination of a preopen down-10 equity futures and up-12 Treasury futures since Oct. 1987.

"Now that bond traders have become stock traders and are anticipating lower stock prices, we take it as a sign this ['death spiral' for stocks] story is fully priced in," Bianco's report concluded.

The recent decline in Treasury yields was also on the mind of Thomas McManus, equity portfolio strategist at Banc of America Securities, who today lowered his recommended bond allocation to 35% from 40%. The proceeds were moved to cash, which rose to 10% from 5%.

Within the bond component, McManus raised his recommended allocation of TIPS to 100% from 67%. Regular Treasuries have "little value" and TIPS will outperform if inflation rises by more than 1.75% annually between now and 2012, the strategist suggested. "Holders of straight bonds stand to lose, especially if we are correct in the belief that the CPI is set to rise at a faster rate over the next year or two."

As for stocks, McManus left them at 55% of his recommended allocation, having upped them by 5% on June 10. A week early, perhaps, but, then again, nobody's perfect.