INTERMARKET ANALYSIS.... WHY IGNORE IT?

BREAKDOWN IN BOND YIELD MAY BE BAD FOR STOCKS ... One of the catalysts behind Thursdays heavy stock selling was the breakdown in Treasury bond yields. The 10-Year T-note yield fell below its July low to the lowest level in more than four months. Bond yields are an indicator of confidence in the economy. When investors are optimistic, they buy stocks and sell Treasuries. That pushes bond yields higher. When they're more pessimistic, they sell stocks and buy Treasuries. That pushes yields lower. So the direction of Treasury bond yields has some bearing on the direction of stocks. That's been especially true over the last two years. The weekly bars in Chart 1 compare the trend of the 10 Year Treasury Note Yield (TNX) to the S&P 500 (green line). At least two things are apparent. One is that bond yields and stocks have usually trended in the same direction. The second is that bond yields have tended to change direction first. Bond yields started dropping during the summer of 2007 several months before stocks peaked. Bond yields started bouncing at the start of 2008 and anticipated a stock rebound that spring. After falling together during the second half of last year, bond yields turned up several months before stocks. Chart 2 shows bond yields turning up in January of this year two months before stocks' March bottom. Bond yields peaked in June, however, and have been weakening since then while stock prices have risen. That "negative intermarket divergence" grew more serious with yesterday's breakdown in yields.

COMPARING TREASURIES TO JUNK ... One of our readers asked whether Treasury prices or junk bonds gave better warnings. I think it's better to use both of them together. Investors buy high-yield (junk) bonds when they're more optimistic and Treasuries when they're less so. In fact, both are giving warning signals at the moment. Chart 3 shows the 7-10 Year Treasury Bond ETF (IEF) breaking out to the upside on Thursday on strong volume. Chart 4 shows the Lehman High Bond ETF (JNK) falling on heavy volume. Both of those trends show more investor caution. [Investment grade corporate bonds also fell heavily on strong volume]. If Treasury prices continue to rise, and junk bonds drop, that would be a more serious warning on the economy and stocks. It's also useful to compare the two bond classes. Chart 5 is ratio of JNK to the IEF. Junk bonds underperformed Treasuries during the second half of 2008 (when stocks were falling), but bottomed in March (along with stocks) and has been rising faster than treasuries since then. In other words, investors favor Treasuries when stocks are weak and embrace junk bonds when stocks are rising. Chart 6 gives a closer view of the JNK:IEF ratio. This week's sharp drop in the ratio is an initial warning of investor nervousness. A drop below the September low would be a more serious warning that investors are starting to abandon risker corporate bonds and starting to favor safer Treasuries.