Monday, September 3, 2012

S&P 500: from 1,400 to 400?

There's a correlation between the  10 year US Treasury and the S&P 500, which represents the 500 largest US companies. Prior to 2008 they moved in tandem when graphed against each other. Take a look at the graph below from 1999 to 2008.

You can see that the orange line tracks the black line very well for much of the last 10 years up until 2008. This was when quantitative easing started. Quantitative easing artificially inflates the price of stocks (along with most everything else) since the stocks are priced to reflect the new, lower valued US dollar.

Since that point the two lines diverge. The question is, when will they re-converge? And will it be because interest rates are rising or because the stock market, represented here by the S&P 500 index, comes down? Its an important question because if rates are held down by the Fed through continued through operation twist, then the index needs to fall from 1,400 to 400!!!

You may recall from my previous post, Three Graphs Explaining When to Dump Gold and Buy Stocks, that I am looking for the Dow/gold ratio to decline to close to 1:1. What these two concepts have in common is that US stocks, whether represented by the broad index of the S&P 500 or the more narrow index of the Dow, will have to decline for these to ration to "revert" back to normal in the case of the US Treasury and to complete an 18 year cycle in the Dow/gold ration.
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Could they converge the other way? Sure, its possible that gold could go to 13,000 to match the Dow and the US 10 Treasury yield could rise to 6%. But I think its unlikely since

  1. The Fed will do just about anything it can to keep interest rates low. The ten year Treasury is the benchmark for many other interest rates, including mortgages. I think the Fed would embark on another QE to buy long dated Treasuries rather than letting that happen. Just imagine what happens to the amount we pay in interest on our $16 Trillion national debt? In 2011 we paid $454 Billion. Imagine if that amount increases by a factor of three or four? We could be paying $2 Trillion every year in interest alone! So I think its unlikely that interest rates will be allowed to rise any time soon.
  2. Though its always possible for gold to rise in value over time, its difficult to imagine it going from $1,690 today to $13,000 without the price of the Dow changing as well. If gold hit $13,000 it would likely be cause by hyper-inflation which would be reflected in stock price as well.

So where does that leave us? Once again, the most likely option seems to be a decline in US stocks due to discontinued quantitative easing. But given that stocks have risen since 2009 on government action, there's nobody but Ben Bernanke who knows what they might do next. As I've said before, these are not free markets. Our "central planners" are determining prices with ever evolving policies. And since there's know way to know what they are thinking and what actions they might take, there's no way of knowing when stocks might drop again. Perhaps never. If Bernanke keeps printing stock prices could go up in nominal price even if they fall in inflation adjusted terms.

Finally, I would just point out that a similar relationship existed in Japan who has been trying to use similar policies to fend of a depression for the past twenty years. In 2006 the divergence between the Japanese 10 year bond and their domestic stock market (TOPIX) ended. You can see the result below:

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