In my review of The Evolution of Technical Analysis: Financial Prediction from Babylonian Tablets to Bloomberg Terminals, I mentioned the 1993 Charles H Dow Award-winning paper, "Charles Dow Looks at the Long Wave" by Charles Kirkpatrick.
The Dow Theory was early technical analysis, and one of his important points was that stock market averages must confirm each other. To summarize:
"[I]f an investor is looking for signs of health in manufacturers, he or she should look at the performance of the companies that ship [their output] to market, the railroads. The two averages should be moving in the same direction. When the performance of the averages diverge, it is a warning that change is in the air."Dow's "theory of confirmation" asks for an "economic rationale for any signals given by the stock market." The Kirkpatrick paper asks how Dow would've revised his theory if he'd lived another 100 years, a period which has seen a number of stock and interest rate cycles but also the diminishing importance of railroads (both as an economic indicator and as a stock market signal).
He surmises that Dow would've found the interest rate market a valuable signal for confirming trend changes in the stock market, although the relationship between stocks and rates is more complicated than the relationship between industrial equities and railroad equities:
"The confusing aspect between long wave interest rates and the stock market is that sometimes both can be moving in the same direction and sometimes each can be moving in opposite directions. This is because stock prices have a corporate profit or growth component, as well as an interest rate or alternative investment component. In the former, stock prices rise as a result of economic growth, industrial expansion, and profitability along with interest rates; in the latter, stock prices rise as an alternative investment to falling yields on fixed income securities. The latter, as we shall see, is more dangerous."Uh oh! Stock prices rising as an alternative to falling bond yields is exactly what has happened over the past couple decades! He goes on to say,
"[T]he peak in interest rates always precedes the long wave peak in stock prices by many years. When interest rates and the stock market are both rising together, the industrial growth component is dominant. The period after interest rates peak is when stock prices rise as an alternative investment. During that period declining interest rates force yield-conscious investors into alternative investments of lesser quality in order to maintain yield. Since stocks are the most risky and least quality investments, they become the final alternative, especially when their price continues to appreciate as a result of increasing cash flow into the stock market. [positive feedback loop] The recent conversion of government-guaranteed CD deposits into stock mutual funds is typical during this period. Unfortunately, it eventually leads to the declining long wave in stock prices."This is an extremely important paper, and concept. I think that this theory fits perfectly with what we observe in the real world right now. Certainly the yield hunger and the flight from fixed income to the stock market, which has the appearance of safety because of the buy-the-dips positive feedback loop. Maybe none of this has had anything to do with quantitative easing at all?
Note that if this theory is correct, the bond market panic or interest rate increase that bond bears are currently expecting will not happen for years, and then only after a stock market crash. The bet made by Stagflationary Mark would then pay out:
"[T]he bond market props up the stock market. The stock market does not prop up the bond market. As a long-term bond investor, rapidly falling stock prices are about as likely to hurt me as rapidly rising stock prices helped me. Not much. The same cannot be said of stock market investors in reverse. As a long-term bond investor, if I am financially ruined then I will be taking stock market investors with me."Heads bond investors win, tails stock investors lose. The beauty of it is that if the stock market crashes, you wouldn't want to own bonds anymore, anyway! You'd want to lever up and buy assets with cash flow, i.e. reverse the trade and sell bonds, buy stocks!
What does this tell you?
- Stay out of equities, except for carefully selected special situations. Don't be net long, don't buy the index
- We have little to fear from rising interest rates. And they seem to have beautiful cycles you can play, based on sentiment and also based on relative yields. With treasuries still an underweight and a analyst consensus for rising interest rates, they should still be a good buy.
- Commodities will almost certainly follow equities lower. Commodity producers have been huge net issuers of stock and debt for their expansion projects over the past several years. The market will be flooded and the stupid buyer (China) would have to increase its rate of boondoggles to maintain price.
- If you want to be aggressive, two great trades are probably super-long UST duration and "donut bets" on mining, E&P, and vendors to the extractive industries.