Thursday, November 12, 2009

The Ultimate Leading Indicator: Yield Curve

As we've been fond of pointing out this year, the leading indicators tell us where the market is going. A lot of investors have fought the trend by concentrating on lagging jobs reports or focusing on future write downs at banks. Those are all concerns, but the leading indicators have told us for months that the future is bright.

One of the best leading indicators around is the Yield Curve. Unlike most indicators whether leading or lagging this one can be followed on a daily basis and doesn't rely on random sampling or questionable government reports. The old addage of don't fight the fed is alive and well. As the chart below shows, when the Yield Curve is above 3% or the difference between the 10 yr and 90 day Treasury bills yields that is the time to buy stocks. Conversely, when the yield flattens out and becomes flat is the time to sell stocks. The negative yields in both 2000 and 2007 were huge warning signs of impending problems.

One interesting note going back to the addage of not fighting the fed. It's usually been portrayed that you shouldn't fight the Fed from day 1 of a change in rate policy. Instead its usually not until the Feds policies change the economic situation up to a year later that you should be concerned.

As we know all to well from 2007/2008 is that even while the Fed cut interest rates sending the yield curve soaring up, the market kept plummeting. Similar to what happened in 2000. The reverse happened in 2004 when the Fed started tightening or increasing rates, but the market kept going up for a couple of years. Ultimately the yield curve became negative and most domestic related stocks hit their peaks in 2006. It was only because of commodity stocks and emerging market growth that major markets peaked in 2007.

Back to today, the yield curve is hanging strong over 3.4% providing huge incentives for the economy to expand. For everybody expecting the impending correction, this indicator suggests it isn't going to happen. In fact, it won't be until nearly a year after the Fed starts raising rates that the economy will suffer and hence stocks should be sold. So many people seem to fear the first rate increase, but instead that's a sign to remain bullish. The Fed Funds Rate going from 0.25% to 0.50% isn't going to derail this economy. Mainly because the following economic reports will be strong making people confident that the higher rates aren't having an impact. Then wham, after the 10th raise in 12 months, the economy will finally stall.

If anything, this leads us to the ultimate issue with the Fed playing yo-yo with interest rates. It takes 12 months for rate changes to impact the economy and yet the Fed decides to make drastic changes within 6-9 month periods. Almost like a kid that embarks on a 12 hour drive and wants to know if we're there yet after 2 hours.

This behavior in Fed policy and the havoc is has on the economy is one reason the 'buy and hold' strategy hasn't worked very well this decade. So many experts claim that the strategy is dead, but we maintain that depends on the Fed and what the Yield Curve tells us. Forget the forecasting, just let the indicators tell you what to do next. For now, they say stay long risky assets.






Note: Our first mention of the hugely positive Yield Curve was on Nov 17th. Basically when most stocks hit bottom. The market made a lower low in March, but the average stock didn't.

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