"Say not, 'I have found the truth,' but rather 'I have found a truth.'"

-- Khalil Gibran

Someone passing by the old quote screen glanced at a chart and exclaimed, in a loosely translated manner, "That looks like Shinola!"

Well, the joke was on him: The eyesore wasn't a stock. It was the yield on 10-year notes over the past year, and it certainly does look like the familiar look-out-below pattern characteristic of too many stocks (see chart below).

The Bull in Bull Market

The 20th anniversary of the Great Bull Market arrived Monday, Aug. 12. Lost in the spectacular stock rally of 1982-2000 is the fact that it started out as a bond rally that carried stocks along for the ride well into 1986. After all, bond yields were more than 16% in the early 1980s, and I still love to see the looks on students' faces when I tell them about 14.5% money market rates. The daily trading pattern of stocks frequently depended on how bonds closed; most of the last-hour rallies in stocks occurred only after a strong close in bond futures.


A Rorschach Test
Source: Bloomberg

More important than ancient history, however, is the consistency of all this with standard financial theory. The fundamental value of a stock is alleged to be the discounted stream of future dividends, and the presence of interest rates in the denominator of this fraction argues strongly for lower interest rates being an unalloyed benefit to equities.

However, we've been training a generation of traders to believe that stocks and bonds move inversely to one another, that bonds only catch a bid in price and a drop in the above-charted yield when stocks are being taken out and shot. To say that this would surprise traders of only 15 years ago would be a mild understatement.

Murphy's Laws

The estimable John Murphy noted the following relationships, among others, in his 1991 book Intermarket Technical Analysis (page 9, original italics):

  1. The inverse relationship between commodities and bonds;

  2. The positive relationship between bonds and the stock market; and

  3. The inverse relationship between the U.S. dollar and the various commodity markets, in particular the gold market.

By extension, the third relationship implies an inverse relationship between the dollar and bonds: If the dollar weakens, commodities rise, and that should push both bond prices and then stock prices lower.

While all of this seemed perfectly reasonable given the experiences of the 1980s and the information available to Murphy at the time, it's in need of updating today. My own research, published here earlier this year, showed no long-term inverse relationship between the dollar and either stocks or bonds . The relationship between the dollar and commodity prices, especially gold , remains stated as above, however.

Although elaborate statistical procedures such as the Chow test can ascertain the stability of coefficients over time, let's take a simpler, quick-and-dirty approach to these intermarket relationships since the peak of the bull market in March 2000.

First, let's examine the relationship between daily returns on the Commodities Research Bureau Index as a function of daily returns on the trade-weighted dollar index. It has held, but weakly, over this period. Much of this anemic relationship is due to erratic euro trading over this period.


Daily Returns on CRB Index vs. Dollar Index
Source: Bloomberg

Next, let's see whether yields on 10-year notes rise as expected when commodity prices rise. Not really: The relationship over this period is pretty close to zero, and we have seen bond yields fall even as commodities have risen throughout 2002.


Daily Returns on 10-Year Notes vs. CRB Index
Source: Bloomberg

Finally, let's add the relationship between bond yields and the Wilshire 5000. The relationship displayed is exactly the opposite of the 1980s experience of stocks rising with rising bond prices.


Daily Returns on Wilshire 5000 vs. 10-Year Notes
Source: Bloomberg

It's Different This Time

The last time we all heard phrases like "new metrics," we all should've run for the hills. The lesson isn't that the fundamental laws of finance are born and die with each passing market cycle, but that each passing market cycle leads us to a different window and a different vantage point from which to view these laws in operation.

Lower interest rates are still good for stocks; it's just that another aspect of equity valuation, earnings, is overwhelming them. Higher inflation is still bad for bonds, but the safety premium for bonds in a bear market is overwhelming it. For that matter, low inflation is good for all financial assets, but low inflation or even deflation caused by imploding demand isn't going to do wonders for stocks, is it?

The key to successful market analysis is remaining flexible: Would a stock analyst who only said "buy" ever be able to keep a job on Wall Street?
Howard L. Simons is a special academic adviser at Nasdaq Liffe Markets, a professor of finance at the Illinois Institute of Technology, 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. The views expressed in this article are those of Howard Simons and not necessarily those of NQLX. As a matter of policy, NQLX disclaims the private publication of materials by its employees. While Simons cannot provide investment advice or recommendations, he invites you to send your feedback to Howard Simons.

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