How High?

“Davidson” submits:

How high a market can climb in any cycle has many inputs all ending in peak enthusiasm at the time, i.e. “Market Psychology”. Everyone will have a reason why markets will not peak at the top, but the historical factor which has helped to time peaks since 1953 is the T-Bill/10yr Treas rate spread.

It works if one treats rates as reflecting investor psychology.

  • Market Pessimism = Lower Rates
  • Market Optimism = Higher Rates

 Market pricing is fluid. Very fluid! Highly dependent on conditions leading up to peaks and especially tied to unexpected events. COVID as just experienced was one of these. Historically, the T-Bill/10yr Treas rate spread has followed the same pattern since we have the rate record. During recessions pessimism is high and rates across the yield curve are low. Typically, fear is so high that 10yr rates fall below that of T-Bills. This is called an “Inverted Yield Curve”. Gradually, some investors envision equity opportunities and sell a portion of their 10yr Treasuries to buy equities. The effect results in 10yr Treas rates rising with a rise in equity indices. Over time other investors follow suit. The widening spread of the T-Bill/10yr Treas rate spread reflects improved optimism and also stimulates bank lending with higher net income margins. As the business cycle gains momentum investors begin to shift ever more capital into equities causing both T-Bill and 10yr Treas rates to rise with the pace of 10yr Treas being higher. Further along in the cycle, investor optimism causes capital from T-Bills to enter equities as well creating a period when short and longer term rates rise in parallel. Speculation begins in earnest when the T-Bill/10yr Treas rate spread is 2.0% level. Still further in the cycle optimism overpowers any caution and speculation begins as T-Bill/10yr Treas rate spread begins to narrow. At market peaks, speculation is high and the T-Bill/10yr Treas rate spread has narrowed to 0.2% levels which causes bank lending to fall sharply. What follows is a collapse of speculation without additional lending. A recession follows investors panic and rates fall sharply across the yield curve. After roughly 18mos of financial restructuring, default and write-offs, the next cycle begins anew.

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The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests ...

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