Stock Buyers Heed the Yield Sign

But is the yield curve really a reliable indicator or just another bullish rationale?
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Lately, a lot of investors have been looking at the

yield curve and salivating for stocks.

The yield curve -- the difference between short- and long-term Treasury yields -- is the steepest it has been since 1993. That's significant because when the curve gets steep, bulls note, it's often a good sign that an earnings recovery is around the corner.

The premise is simple: Shorter rates, like the two-year note's, are tied closely to the overnight

fed funds rate. Longer rates, like the 10-year's, however, are more about the market's perception of future

Federal Reserve

policy. A steep yield curve is a forecast for an economy in which the Fed will soon be raising rates. The Fed starts raising rates only when the economy is growing and there's a threat of it overheating. And that's typically the kind of economy in which companies are gathering in some serious coin.

"For the past nine months, the yield curve has been arguing that the profit cycle should trough within 12 months," says Merrill Lynch quantitative strategist Kari Bayer. In other words, profits could be picking up again as soon as March. Which is nice.

The problem, says Bayer, is that almost all the other profit indicators she looks at, particularly the shorter-term ones, are forecasting an earnings slide.

It's not impossible for the yield curve to be giving a false read. For one, the curve is a function of bond market action, and markets are often good forecasting tools, but not always. Moreover, notes Fuji Futures strategist John Vail, the stock and bond markets may be in the grips of a tautology.

"People look at the rise in stocks and say it means the economy is going to get better," he says. "And if the economy looks better, then yields rise."

Curve Ball?
Spread between two- and 10-year Treasury yields

Source: Federal Reserve

And then, to complete the trope, the yield curve gets steeper. And people say the time has come to buy stocks. Neat, huh?

But perhaps the best thing to do is to take a look in the history book at the last time the spread between the two- and 10-year yields rose through 200 basis points, in December 1991. The Fed kept cutting rates and the curve kept getting steeper through much of the year. But by December 1992, the

S&P 500

was only 4.5% higher. The spread reached its peak in October 1992, a month after the Fed's last cut of that cycle. In the following 12 months, the S&P 500 rose 11.7%.

In other words, maybe right now ain't the greatest entry point into the market. Maybe it comes when the Fed has closed the book on its easing cycle and the slope of the yield curve begins to ease.