Signal Type	Trade Date	Index	Return since issued
		Nasdaq 100
		Russell 2000
		S&P 500

Market Update

It has been a tough week on Wall Street. Shrugging off big losses on the Chinese market, stocks posted gains Monday in the continuation of last week's rally. They then reversed course for the next 3 days, largely because of talks of possibly higher interest rates. The markets started their retreat after Fed Chairman Ben Bernanke commented that the economy is showing signs of improvement. Bond investors reacted to the news by sending yields higher, as they interpreted Bernanke's remarks as a sign that the Fed won't be inclined to cut interest rates any time soon. The negative action in the bond market resulted in losses for stocks. The selling continued Wednesday after the Labor Department announced that labor costs increased by 1.8% in May. The number was much higher than expected and again raised inflation fears. Rising oil prices also contributed to the slide in stock valuations. As bond prices experienced another big drop Thursday, so did stocks, with the Dow Jones Industrial Average losing almost 200 points on the day. The market was finally able to stop the bleeding Friday to finish the week on a better note, with the indexes recovering a good portion of Thursday's losses on bargain hunting.

The Nasdaq 100, S&P 500 and Russell 2000 respectively lost 1.14%, 2.13% and 1.87% on the week. All 3 indexes remain above both their 50-day exponential moving average (EMA) and 200-day EMA.

For its part, our World Index Ranking portfolio underperformed the US averages as it posted a 2.14% loss this week. The portfolio consists of the 5 top-ranked world indexes as of May 25, which marked the beginning of the current 4-week holding period.

Our current Buy signal remains in effect.

Trend Timing School

Interest rates at a crossroads

We frequently review in these pages some of the serious issues which individually and collectively threaten the economy, but the stock market which always looks ahead as a leading indicator for the economy, notwithstanding the short-term pullback, is currently telling us that there will not be a recession anytime soon. The fabled soft landing may actually come to pass. When looking to explain why the bull market in stocks has continued unabated in the face of all the challenges the economy faces, one must identify the key drivers. While the stock market is an extremely complex jig puzzle with many interlocking parts and cause/effect connections, in our analysis, interest rates (low) and liquidity (high) are the key driving forces behind this bull market. Because of significant developments occurring in the sphere of interest rates, we will temporarily shelve the liquidity topic.

Interest rates are set in the market place by supply and demand for the various debt instruments. Bond investors, for example, will exit their positions if they believe that yields will be going up in the future. Since bond prices move opposite to the yield, when more investors sell their bonds they increase the supply, which pushes prices down and rates up. The reason all of this matters to us as stock investors is that higher interest rates make everything more expensive for individuals and corporations alike. Rising interest rates negatively affect the economy, but the sheer perception of future rises in interest rates can negatively impact the stock market.

Much of the news this week, and in turn the perception of the markets, was about rising rates with the European Central Bank hiking its key interest rate to 4% citing the euro-area economy which, unlike the U.S., continues to expand at a stronger pace than expected. In contrast, the corresponding U.S. Fed rate has been steady at 5.25% since June of 2006. U.S. long rates have been spurred upward by recent comments by Fed Chairman Bernanke which hinted that the economy might continue growing despite the worsening housing sector, taken by some as a sign that they may not need to lower rates any time soon. Yet, to get a complete interest rate picture it is wise to look at both the short and the long term maturities.

A glance at the short 90-day Treasury yield depicted in Chart 1 below reveals that short rates have actually turned down. Technical indicators have been confirming the reversal as has the recent crossing of the important 65-week average.

Chart 1: 90-day Treasury Bills rate reversal



The bond market is telling us that after nearly 3 years of climbing short rates, the major trend has now turned down. While much of the recent public commentary by Fed officials has been hawkish, with a focus on staying vigilant against possible inflation increases, the bond market is now confirming what often transpires from the Fed meeting notes, that they are in fact a lot more worried about the slumping housing industry and the slowing economy. This also suggests that the Fed's next interest rate move is more likely to be down then up, contrary to the perception created this week. This is a good place to remember that to predict Fed policy someone has to be willing to make an even greater fool of themselves than those who predict markets.

On the long-term front, the 10-year Treasury yield has joined the longer 20 and 30-year bonds above 5% this week. The reason the market took notice is that it potentially represents a momentous shift in the bond market. As can be seen in Chart 2 below, the bond bull market has lasted about 27 years since 1980. There is no certainty yet, but a clear indication by the market that long rates are moving higher in the future.

Chart 2: 30-year Treasury yield looking to reverse megatrend



We will know with certainty over the next couple of years if what we are experiencing now is the beginning of a generational bear market for bonds, and if it is, the implications for the economy are enormous. It takes a look back to the 1970s to remember what a rising interest rate period can be like.

The divergence between short and long rates is not that unusual and occurs from time to time, especially when the natural balance of the yield curve needs to be restored. An upbeat consequence of the dichotomy between short and long yields over the last few weeks is that the much dreaded yield curve inversion is no more. Be sure to read "What is a yield curve inversion?" in this week's FAQ below.

To distill down the current interest rate picture, the short-term rates are telling us that for the next couple of years the trend is down which is bullish for stocks, and that the long rates anticipate higher inflation further down the road, which will eventually hurt the economy and the stock market.

But interest rates play no direct part in our Model and neither do any other fundamental indicators. Still, as they influence the stock market, our Model indirectly follows the changes in trends and perceptions about interest rates.

FAQ of the Week

Question: What is a yield curve inversion?

A yield curve plots the relationship between interest rates (known as yields in bonds vernacular) and the time to maturity of a particular debt instrument. Under normal circumstances the yield for shorter term bonds is less than that of longer maturity ones, as depicted in the left part of the chart below. The graph shows the evolution of yields for various U.S. Treasury Bill maturities over the last 24 months. An inverted yield curve occurs when long-term yields fall below short-term yields. As we have been documenting in these pages (see for example "What is your take on the inverted yield curve?)", the interest rate yield curve has been inverted since 2006.

Reversing the yield curve inversion



An inverted yield curve is interpreted by many as a bad omen for the economy and the stock market because such an abnormal condition would seem to indicate that long-term investors are willing to lock in lesser rates now because they anticipate a slowing economy down the road, and lower yields yet. As evidence, they point to studies which have shown that each of the last six recessions was preceded by a yield curve inversion. What they do not mention is that not all yield curve inversions have resulted in recessions, and at least one of them (e.g. 1992-1994) resulted in the biggest bull market in history.

Regardless, the fact that the yield curve has been righting itself over the last few weeks, with short rates dropping and long rates climbing above 5% again, is welcomed by many as a positive development.

Warm wishes and until next week.

The TimingCube Staff