TimingCube - Interest rates and the stock market - interest rates,Nasdaq re-ranking,interest fed fund rate hike, yield spread,yield curve inversion

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Signal Update

Current Signal Performance as of

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

Cumulative Returns since First TimingCube Live Signal () as of

Index	Long Only	Long Only with Margin	Long & Short	Long & Short with Margin	Buy & Hold
Nasdaq 100
Russell 2000
S&P 500
QQQQ

Note: QQQQ returns are included for continuity sake.

Market Update

All-in-all this was another rather quiet week of consolidation. Markets began on the expectancy of the Tuesday meeting of the Federal Reserve Board's Open Market Committee and their interest rate pronouncements. Stocks surged on the Fed announcement, not as much for the widely expected quarter point rate hike to 4.25%, but for the language they used in the release. Specifically, the word "accommodative" disappeared which pundits read as meaning that the Fed is nearing the end of its uninterrupted series of increases. Nevertheless, as the week progressed little buying enthusiasm could be found. Even the financial news media trumpeting an unexpectedly big drop of 0.6% in the November CPI reading could not get the markets moving (the CPI tracks consumer prices and inflation and a decrease should be good for stocks). Maybe investors could see that without energy costs which had declined over 8% for the month, the core CPI actually rose 0.2%.

The large caps of the S&P 500 resisted well but the small caps and technology issues took a tumble. As expected on a quarterly options expiration day (the so-called quadruple witching day), Friday's volume and volatility increased as markets declined. For the week the primary indices we track ended mixed, with the S&P 500 edging out its peers with a 0.63% advance, while both the Nasdaq 100 and Russell 2000 lost, -0.23% and -0.82% respectively. The subdued market action did not change our Model's current Buy status.

Trend Timing School

Interest rates and the stock market

With the Fed raising the short term rates for the 13^th consecutive time since starting back in June of 2004, many of us are reminded of the uneasy relationship between interest rates and the stock market. It is generally understood that over time higher interest rates are not good for the stock market and many like to repeat the old "Don't fight the Fed" saying. Maybe a more compelling reason to pay attention now is that many economists believe that interest rates are rapidly approaching a critical crossroads.

There are actually many types of interest rates and, contrary to popular belief, the Fed does not really set any of them. The federal funds rate is really a target rate that banks charge each other for overnight loans. This only indirectly affects the rates of other debt instruments such as bonds of various maturities. The actual yields of the U.S. Treasury Bills and other instruments is set by supply and demand on the open market. While short term instruments such as the 90-day Treasury Bills follow the Fed rate closely, longer term rates can have a mind of their own. Under normal circumstances longer-term bonds such as 10-year or 20-year maturities pay much higher rates because investors must tie up their money for the long term. Chart 1 below depicts the evolution of the Fed funds rate and longer maturities of T-Bills.

The yield curve is a graph plotting Treasury yields by maturity which, under normal circumstances, shows an upward sloping line with higher yields for longer maturities. Over the last year and a half the yield curve has been flattening, which is what happens when the yield spread, the difference between long and short-term rates, narrows. Yield curve and spread is watched as an important indicator, especially after prolonged periods of shrinking spread. If this trend continues we will face a yield curve inversion, which is when long yields fall bellow that of shorter maturities. In the past, such inversions have often preceded recessions by a few months.

Chart 1: Fed Funds Rate

Looking at the chart it is plain to see that so far the Fed tightening has not affected long term rates, and the market which sets interest rates has been counteracting the Fed's efforts to control growth with higher interest rates. One possible explanation for the long rates coming down in the face of rising overnight rates is that the bond market is not scared of inflation, possibly because of the Fed's first-rate track record in keeping it under control. Still, many economists believe that the ten-plus year trend for lower interest rates and higher bond prices is about over.

Why does the direction of interest rates matter so much to investors? Interest rates are widely watched because of their influence on the economy and on many markets. Because they are an influence, and because in time their movements impact the economy and the stock market, they are also a leading indicator.

When interest rates rise it costs companies more to borrow money needed to operate and expand and as a result businesses begin to scale back. As they cut projects or plants, there are many purchases from suppliers and contractors that are delayed and cancelled, and as this phenomenon spreads through markets the economy slows down and enters a recessionary phase. As companies' revenues shrink the first thing that evaporates is profits, which in turn will reduce the Government future tax receipts. As the Government's income shrinks, the cost to carry debt increases with the rising rates, causing deficits to mushroom. In efforts to stimulate the economy Governments have two primary choices: to drive interest rates back down or to inject more liquidity into the system, or both. As interest rates come back down the growth circle begins anew.

Not mentioned in this scenario but of primary importance are the consumers which have a similar role and interaction with interest rates. When interest rates rise it costs the consumer more to borrow and carry debt. The monthly payments on many adjustable rate mortgages go up with interest rate hikes and the price tag on new ones gets bigger. Real estate is one of the most interest sensitive markets there is. And it so happens that it has been the primary force behind the strong economy we have experienced over the last few years. The interesting side effect of a slow down in the real estate market is that billions in investment money would shift to more promising areas, and this would in part benefit the stock market.

We cannot tell from short term interest rate moves when the stock market will react. We know there will be an impact but to determine when the time has come to take a bearish stance we will have to rely on our time tested trend following Model.

FAQ of the Week

Question: What is the impact of the Nasdaq 100 index re-ranking?

Yes, what we alluded to with the Google addition rumor in our December 2, 2005 FAQ of the Week will officially take effect on Monday December 19, 2005. This week, the Nasdaq officially announced the results of the annual re-ranking of the Nasdaq Composite index, as well as the resulting company additions and deletions for the Nasdaq 100 (see Table 1 below).

This type of index reconstitution and the attendant company shuffling happens on a regular basis and should be of no concern to us. There can be somewhat increased trading volume in the related issues on and around the day the change takes place but by and large there is no lasting effect.

Table 1: December 19, 2005 Nasdaq 100 re-ranking

Added		Removed
Google Inc.	GOOG	Career Education Corporation	CECO
NII Holdings, Inc.	NIHD	Dollar Tree Stores, Inc.	DLTR
Expedia, Inc.	EXPE	Intersil Corporation	ISIL
Patterson-UTI Energy, Inc.	PTEN	Invitrogen Corporation	IVGN
NVIDIA Corporation	NVDA	Level 3 Communications, Inc.	LVLT
Urban Outfitters, Inc.	URBN	Millennium Pharmaceuticals, Inc.	MLNM
Cadence Design Systems, Inc.	CDNS	Molex Incorporated	MOLX
Activision, Inc.	ATVI	Novellus Systems Inc.	NVLS
RedHat, Inc.	RHAT	QLogic Corporation	QLGC
Monster Worldwide, Inc.	MNST	Sanmina-SCI Corporation	SANM
CheckFree Corporation	CKFR	Synopsys, Inc.	SNPS
Discovery Holding Company	DISCA	Smurfit-Stone Container Corporation	SSCC