Tuesday, September 26, 2006

What We Can Learn From Market History

Historical precedent is an extremely fallible guide to future market behavior. In fact, the only investment strategy worse than relying on history is one that ignores history.

After hearing yet one more trader wax optimistic about stocks rallying when the Fed cuts interest rates, I put together the above chart. What we see is the difference in rates between the 20 year bond and the 26 week bill (red line) vs. the S&P 500 Index.

Notice that at the market top in 2000, we had an inverted yield curve. The bills returned a higher interest rate than the bonds. A similar inversion occurs as I write. What happened when the Fed began aggressively cutting rates, sending the bill yields lower (and the yield spread higher)? Observe how the market tanked all during the initial period of easing.

Is this a universal pattern? No. Short rates climbed steadily in 1994 and the stocks underwent a mild but extended correction. Once the Fed eased rates early in 1995, we began a significant rally in stocks.

What is more important than absolute rates, perhaps, is how fixed income competes with equities for capital. At market tops, we've tended to see the spread between fixed income yields and equity yields well above their moving averages. At market bottoms, we've generally seen the reverse. Thus far, fixed rates, especially on the short end of the curve, compete quite nicely with equity yields. It's when fixed rates become non-competitive on a relative basis that stocks tend to attract interest.

Oh yes; one more historical precedent. Friday was a day in which a large number of stocks displayed significant downside momentum, with my Supply measure (an index of the number of issues closing below their short- and intermediate-term volatility envelopes) exceeding 100. Monday, however, showed significant upside momentum, with the Demand measure exceeding 100.

We've only had 10 occasions since 2003 when we've flipped from strong negative to strong positive momentum in a single session. Four days later, SPY was up by an average .58% (7 up, 3 down)--much stronger than the market's average four-day gain of .17% (522 up, 408 down). Five of the last seven of those occasions during 2005 and 2006 have been profitable four days later.

History doesn't tell us everything, but it's very difficult to find market professionals who have sustained long-term success who don't bring a historical perspective to the table.