Stock and Bond Relationships Without All the Noise
Contrarians are Most Effective when they are the Loneliest
by Martin Goldberg CMT. November 3, 2004
The intermediate term chart of the Nasdaq and the Ten Year Treasury note price look relatively choppy with a bearish overtone of lower lows and lower highs, while the S&P 500 has exhibited similar behavior with less volatile fluctuations. Yet if you strip the loud noise from the charts, you can see some important trends developing which may provide insight into the future of these markets in relationship to each other. It is also possible to gain some insight into likely future performance of stocks and bonds. With the stock market rallying in what seems to be the most vertical "V" rally of 2004, is it time to get on the party hats and buy stocks for the long haul? This would not be a good idea because what we are seeing in the stock market is probably a gigantic head fake in my view. The longer this top takes to complete, the more important and devastating will be its ultimate end. I'll present my case with both time/price and point-and-figure charts.
The chart below illustrates a long-term weekly chart of the 10-Year Treasury note. The indicator that is on top of the chart is the 10-year note price divided by the S&P 500 index, and there are also momentum indicators below the chart. As you can see, since spring of 2003, the 10-year note has followed a fairly regular pattern of lower lows and lower highs. When it has fallen (twice) it has fallen fast; when it has risen, it has risen slowly. The chart shows that the Treasury note sits just below the trendline that connects the lower highs. The Rule of Alternation suggests that the next drop will not be similar to the last drop; yet the Rule would have also suggested that the last 2 consecutive drops would not have been be similar, either. I suspect that the reason that the drops were similar were because the underlying factors causing them were also similar. Whatever the reason for the trendlines, they seem very much intact and suggest a bond market drop soon, at least from a classical technical analysis perspective. This potential is also suggested by the lower highs and lower lows shown in the momentum indicators, illustrated in the chart below.
The indicator above the chart shows the 10-year note price divided by the S&P 500 index. When the line is heading up, the 10-year note is outperforming the S&P 500 index. As you can see, this chart has formed a long regular rounded bottom dating back to the beginning of 2003, and looks poised to rise. In order for the strong (up) trend to continue one or both of the following must occur:
- The 10-year note price must rise from its current level, and/or
- The S&P 500 must fall.
Since the fed has told us as late as last Friday that short term rates would continue to go up, does it seem likely that the bond market will rise much from here? The probable way the uptrend will continue is for a drop in the S&P 500 to occur. If the bond price falls and the S&P falls faster, that would also preserve the uptrend. Of course, if the intact green trendline were to be broken, that would suggest that the S&P 500 could rise while bond prices fall. However, the green trendline appears as smooth and regular as any trend seen in the current markets, so for now, that trend must be given the benefit of the doubt. Most recent daily action challenging the trendline based on the recent presidential election rally (not confirmed by the bond market) is probably not anything that will be sustainable beyond a couple of weeks. If you pull back and look at a two-year daily chart of the ratio, this becomes more apparent.
By examining the point-and-figure charts of the 10-year note and S&P 500, you can see the bearish overtones of both of these indices. While as with any charting technique, no chart is perfect, point-and-figure can sometimes filter out "noise" and provide the analyst with a clearer picture of what's going on. For the charts below, I used a 1%, 3-box reversal scale.
Point-and-figure charts are showing bearish price objectives for both the 10-year Treasury and the S&P 500. Below is a similar point-and-figure chart of the ratio of the 10-year treasury divided by the S&P 500 that is analogous to the chart with the green trendline, above. The point-and-figure perspective is more neutral that the green trendline above since it appears to be in a triangle formation that is not yet resolved.
Below is a daily chart of the Nasdaq index with trendlines indicated.
This morning at the opening, the index appeared to have whipsawed the upper trendline as the Nasdaq finished the trading day just below the trendline. The sharp "V" shape of the miraculous recovery that began in early August is worth examining. The last 2 multi-day rallies (beginning in early and late October), are almost vertical – likely occurring from short-covering and fund managers chasing high beta stocks with intent to not miss out on a good party. In the backdrop of this market, the financial media's spin that the market would rally for the incumbent's election has sent contrarians such as me, frustrated once again. So should contrary thinking be abolished as a successful means of viewing the stock market action? Unlikely. Long-term history has shown that the media experts are the most wrong at the most inopportune times. This has always been the way that the relatively uninformed speculators with the least wisdom lose their wealth to the big guys. While being a contrarian may be out of style at the moment, styles have a way of changing rapidly.
In order to glean some perspective and insight into the stock market's short-term future, I would like to examine two stocks that most illustrate the market's emotions – Google (GOOG) and Yahoo (YHOO). Although these are successful businesses, I think that it is safe to say that there is a giant disconnect between the company's actual valuation and their valuation in the stock market. I think that for all practical purposes, you can consider their actual company valuation to be negligible in comparison to their stock market valuation. These stocks also trade manically as the average floating share of Google changes hands every 5-days. Because of the valuation disconnect and manic trading, the action of these stocks can be considered as a gauge of the stock market's current optimism or pessimism level. The Internet leaders of 2000, Amazon and Yahoo peaked in advance of the entire Nasdaq market.
Below is a short-term daily candlestick of Google.
Google is putting out several bearish candlesticks and appears to be forming a top. The "down" action three days out of four is significant given that the Nasdaq market has had three out of four "up" days.
Yahoo broke out of an apparent double top the last few days, and surged yesterday, apparently for no other reason than it broke through a 52-week high. In this speculative market, that is generally the most coherent reason that speculators would buy a stock such as this. The latest Yahoo buying surge came off of a sharp "V" reversal and seems to be driven by panic buying. If Yahoo were to drop below the former top (indicated by the blue line), momentum could pick up to the downside. The preponderance of gaps on the Yahoo chart and the manic trading of yahoo (hold time = 60 days), suggest that perhaps these gaps will all be filled. Yahoo's price is the same as it was near the top of arguably the biggest stock market mania of all time. (October of 1999).
Today's Yahoo action was not bullish. Although it finished higher than it finished yesterday, it closed well below where it opened. You think those people who bought Yahoo today based on the election will hold if it gains downward momentum? You think those who bought based on the breaking to the upside of the 52 week high will hold if Yahoo goes down by 2-points? While Yahoo looks good on the surface, the most recent action shows a stock that may be rising as it is being distributed to the public as shown in the chart below.
I think that if Yahoo whipsaws its 52-week high and Google continues in its bearish patterns of the last week or so, it could spell trouble for the Nasdaq in general. In my view, the Nasdaq cannot surge if it has its emotional heart cut out of it. It's a long way down for the Nasdaq. Will there be an incumbent re-elected to the presidency again tomorrow?
The S&P 500 matched its June high but couldn't close above it. Volumes on all three indices were relatively high. Here's a 6-month chart of the S&P 500. It has made a short term broadening pattern and now sits at the top of the trendline defined by the higher highs.
Oil was up $50.88, Gold up $2.40 (426.5), silver up $0.07 (7.19), the XAU up 2.4% and the HUI up 3%. The 10-year note was little changed. An index that is at a critical stage is the dollar index. It will be important if the dollar breaks key support or whipsaws fast and tradable. It is hanging by a hair as shown in the chart below.
If the support is broken decisively, then head and shoulders measurement principles suggest that it could go to about 80. This is confirmed by the point-and-figure 3-box reversal chart, which indicates a preliminary price objective of 79 for the dollar index.
Have a great evening!
© 2004 Martin Goldberg