Dec 10, 2013

Beeping Red Light Alert on the US Stocks to Long Bond Price Ratio

Traditional FED Model supposes that the Earnings Yield on S&P500 and the US 10 Year Long bond are in equilibrium. To check how and if this worked in history, I created a spread chart on a weekly closing basis subtracting the 10 year long bond yield from the earnings yield of S&P500 as shown in the chart below:

This spread measures the equity risk premium which refused to go positive through 1983 to beginning of 2003. Many times this risk premium came and found resistance at the zero level during this 20 year long period.

However, from 2003 to now, there is a continuous upward "Drift" in this indicator / variable / statistic. It has refused to go down below zero few times in this new regime, but has a strong uptrend regression channel. Until this "drift" breaks down, I am comfortable to surmise that the Equity Risk Premium in the United States is on a long term incline.

Definitionally, I disagree with the too much approximation such an idea does since the Earnings Yield on S&P is arrived at by taking historical earnings divided by Market Price, whereas the Bond Yield has anticipated cash flows of future more clearly.

So I worked around and tweaked this idea RESPECTING the Market Price way more than anything and created the SIMPLIFIED FED Model by dividing the price of the S&P500 near expiration futures with the US Long Bond near expiration futures. Why?

The price of an equity index discounts all possible future cash-flows at the ever changing “appropriate” discounting rate that is market-implied. Comparing price of equity index to price of long bond thus removes the conundrum of driving by looking at the rear view mirror.

A fantastic clarity emerges on this price ratio chart, that I am naming as the Market Implied FED Model:

PRECISELY 1 week ahead of the top of 2000, 1 week ahead of the top of 2007 and 1 week ahead of the bottom of 2003 and 2009 this ratio chart had Sell and Buy signals.

For those who are more quantitatively inclined each of these prior 4 key tops & bottoms, this ratio went past +2 and -2 std deviations respectively.

This present week, Price ratio is already past 2 standard deviations, RSI of this ratio is divergent too. Hence, if in the next week US long bond price performs better than the S&P500 futures, it could be a firm shrill whistle of a market top coming for equities.

This indicator and this note are pre-emptive, only a warning sign-post. The perils of forecasting place one sometimes before a grinding road-roller too. Nothing is permanent, indicators included. But then, I must find some reason to believe why this excess in the relative performance of stocks to bonds in the United Stated will defy a 13 year long relationship now!

Until I find a rationale, I will keep a close eye on the relative performance of long Bond and SnP 500 through the next week. More or less everyone has become complacent of a world that will remain permanently healthy on steroids.

If indeed the US Long Bond starts moving up sustainably from here while FED taper is lurking around the corner, how shall we reconcile to Bond Price Rally without significant yield decline? Well when a flight to safety becomes necessary, the trouble could actually be coming to this world from an origin that is not yet on the oceanographs. Which economies will uncoil relatively stronger rate rises making the US Long Bond a safe haven?

The Market Implied FED Model is what I call my simpler and more realistic one. It is beeping a red light alert!

1 comment:

Karthikg said...

Interesting and to some extent true as the markets TOP out in the short term around Dec 18 and PLUNGE towards DOW 14000 by March end.But the final TOP is yet to come and may be delayed by a few quaters as the DOW bounces back from 14000 towards 17000 before its all over next year.Indias Nifty to PLUNGE from around 6390 odd levels to 5100-5300 by March end.That should be the bottom and not 4500 as many expect.The markets will surprise the perma bears in a global UP frenzy post March 2014.