Stocks and Treasuries: Is One Market Smarter?

If this ratio is compared with the logarithm of the deflated S&P 500, we see almost no discernible pattern of causality. The late-1990s bubble occurred in the face of a flattening yield curve. The recent bear market has occurred in spite of the most panicked reaction on the part of the Fed since 1958, a year which seems to be getting a lot of attention in interest rate circles of late.

Steeper Yield Curves Don't Help Stocks

Source: Federal Reserve, TSC Research

If the stock market in turn is supposed to discount future corporate earnings, we in turn should conclude that all of the Fed's histrionics and incantations have no effect whatsoever on the real economy. Let me repeat, none. They have no more effect than a Stone Age shaman in New Guinea does in leading a cult ceremony, and while my basis for comparison is somewhat incomplete, I suspect they are less entertaining. And yet we let the FOMC play with matches.

Comparative Prediction

In testing for whether either market can forecast industrial production or unemployment, we once again will use the concept called Granger causation. Just like last week in our discussion of stocks and corporate bond spreads, we have to conclude that neither market is truly causative.

However, stocks once again get the advantage. Returns on the deflated S&P 500 lead changes in industrial production and unemployment with lags of three and seven months, respectively, with R-squares of 5.70% and 2.93%, respectively.

Returns on 10-year notes had much shorter leads, one month and no lag, respectively, and R-squares of 0.48% and 0.57%, respectively, for industrial production and unemployment. Both macroeconomic variables explained themselves -- autoregression -- at much higher R-squares, 10.50% and 7.41%.

Edge for Stocks
Autoregressive
Ind. Prod		Unemployment
10.50%		7.41%
Cross Dependent
Independent	Ind. Prod	Unemployment
S&P 500	5.70%	2.93%
Ten-Year	0.48%	0.57%
Source: TSC Research

The first two tests of stocks and bonds indicate that when the two diverge, stocks should be given the benefit of the doubt. In the present situation, this means we should be placing greater faith in the combination of stronger equities/weaker dollar/narrowing corporate bond spread than in the giddy Treasury rally.

Yes, you can pour your life savings into 10-year paper yielding less than 3.5%, fully taxed and with no protection against inflation should it recur as a problem, which is still my bet. Implicit in this investment is a belief in the powers of the Federal Reserve to affect the world as it intends. At this point, I would recommend abandoning Orwell as a political philosopher and following the teachings of Clint Eastwood: How lucky do you feel?

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