Bonds and Stock Market Bottoms

08/31/01 02:04:26 PM

by David Penn

Will a test of the spring highs for the 10-year Treasury also help establish a bottom in the S&P?

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John Murphy may not have been the first to point out the technical relationship between the bond market and the stock market. But his Intermarket Technical Analysis should be mandatory reading for all those interested in making more of those connections. Connections like these can be especially helpful in a time when any one market--be it equities or debt, commodities or the dollar--seems especially impossible to understand. With the current tug of war in the major equities markets remaining unresolved as we head into the fall, I looked to intermarket analysis in hopes of discerning some direction in the S&P.

One of Murphy's primary assertions is that bond prices and stock prices tend to move in tandem. While granting that a time lag can exist between the two--and especially during changes in trend--Murphy believes strongly that bull markets in stocks must be accompanied by bull markets in bond prices (in fact, he tends to suggest that bonds lead stocks in this regard). Similarly, Murphy notes that breakdowns in bond prices almost always, sooner or later, spell trouble for stock prices. Drawing largely upon market action in the 1980s, Murphy's work is convicing enough to merit comparisons with other time frames, such as the markets in the second half of the 1990s going into the bear market of 2000-2001.

While the S&P 500 tests an intermediate low, the 10-year Treasury note tests an intermediate high. A retreat in Treasuries could mean a rout to stocks.

Graphic provided by: MetaStock.

While far more volatile than the S&P 500 between 1995 and 1998, the 10-year Treasury note (our bond market proxy) was in an uptrend from 1995 until 1999, which corresponds well with the uptrend in equities during the same period. However, the bond market began to collapse early in 1999 and, by the time the year was well underway, bond prices had severely deteriorated, finally bottoming early in 2000. During this time, as most will recall, the stock market continued to climb--even as anxieties over "irrational exuberance" grew greater by the trading day. But ironically, mere months after the bond market reached a bottom, the stock market itself began to crumble. While bonds have rallied strongly since 2000 (the 10-year Treasury rose by 12% in 2000, although it has oscillated between 106 and 102 in 2001), the stock market has continued to decline. As of August 30, 2001, the S&P 500 stood 24% off its high.

These divergences between bonds and stocks are important. In fact, the divergence between bonds and stocks that began in 1999 was one of a number of signals that the stock market advance was headed toward technical difficulty--which it did several months later. Understanding what these divergences mean could also be helpful now, when the bond market has been trending upward for 1.75 years and the stock market has been trending downward for a year. Unfortunately, as Murphy suggests, while a falling bond market is always bearish for stocks, a rising bond market does not necessarily mean a rally in equities is imminent--especially during a bear market, when poor corporate earnings and increasing investor preference for bonds can keep stock prices from appreciating.

So what does the current holding pattern in the 10-year Treasury mean for the current holding pattern in the S&P 500? If the Treasuries move up above the year-to-date highs, then there may be little that can be deduced for equities traders and investors. But if the 10-year Treasury fails to make a new high, then those who have been anxious about the stock market all summer long may finally have reason to don their bear suits and zip themselves up to the chin.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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