Equities outlook: A new bull cycle?

July 31, 2009 07:00 PM

Another argument used to justify a gloomy outlook is the perceived adverse impact on consumers as a result of the rising prices for crude oil. From a low of about $33 a barrel late last year, prices have more than doubled to above the $70 level. The bears believed that higher energy prices were mainly due to supply constraints and they refused to acknowledge the possibility that rising energy prices could be a result of an actual increase in consumer demand.

The bears pointed out that executives at U.S. corporations recently were selling their shares in their companies at the quickest rate in the past two years. Corporate insider activity is thought to be an indication of future stock index direction. In addition, there were concerns that corporations were selling too much new equity to the public in order to replenish cash reserves. How could stock index futures continue to advance in the face of substantial insider selling in conjunction with vast amounts of newly created stock being offered to the public?

At first glance, all of these arguments appeared logical and worthy of an actionable response. Even now, the bearish fundamentals cited on the way down are still valid on the way up. However, there is one problem in common with all of them. These arguments for further economic weakness and lower stock index prices are either concurrent or lagging indicators that have already been factored into the marketplace. While it is true that the bears on the economy and on stock index futures have the most number of arguments to support their beliefs, they do not have in their camp the most important indicator.


A much more important and leading indicator of the direction of the economy and the likely direction for stock index futures can be found within the subtleties of the interest rate market complex. The recent upward pressure on short-term interest rates is not as bearish for the economy and stock indexes as it first appears. At this stage of the economic cycle, it is a bullish indication, since higher short-term interest rates are an indication of greater loan demand in the near future.

Another major indication of future economic activity lies within the shape of the yield curve, especially at the short end. Although there is no crystal ball when it comes to predicting the economic future, there is one indicator that may come the closest. The “yield curve indicator” is often overlooked and underappreciated. To best understand the predictive qualities of the yield curve, it is necessary to study the characteristics and shapes of the different types of yield curves and what we can expect from them based on what has happened in the past. Most of the time, the yield curve is considered to be “normal,” having an upwards slope to the right. An example of this is when short-term debt instruments carry lower yields than those of longer dated maturities. This relationship is logical because debt holders generally demand a higher rate of return for taking on the additional inflation risk when holding longer term debt obligations for longer periods of time. This “normal” yield curve is consistent with a healthy economy that is growing (see “What is normal”).

However, during the last part of 2007, in 2008 and earlier this year, when the economy was faltering, the shape of the yield curve was just the opposite of the normal yield curve. That is, it was inverted with yields being higher for the nearby maturities than those for the more deferred debt obligations. A yield curve with this shape is a rare occurrence, which on the surface does not appear to make economic sense. Why would any investor be willing to earn a lesser rate of return for undertaking the inherently greater risk of holding longer term debt, when they can receive greater yields by investing in shorter dated debt market instruments? A yield curve with this shape is associated with an impending economic downturn. Since 1960, an inverted yield curve has tended to precede economic softness.

It now appears that the yield curve inversion and all of its negative economic implications has run its course. The yield curve is normal again and is a very strong indication that the worst of the economic decline has passed (see “The greenest of shoots,”).

We can expect a gradually strengthening economy this year followed by accentuated growth next year, along with advancing equity futures prices. How high can the S&P 500, Dow Jones, Nasdaq and Russell futures go before they top out? S&P 500 futures are likely to find major support in the 810 to the 835 area, with major resistance coming in at 980 up to the psychologically important 1000 level. Chart support for the Nasdaq 100 comes in at the 1300 to the 1340 level and resistance at the 1705 to the 1815 range. Technical support for the Dow Jones futures can be found at the 7620 to the 7760 area and significant overhead price resistance comes in at the 9200 to the 9400 level. Given the bullish implications of the yield curve influence, stock index futures are likely to underreact to bearish news and overreact to bullish news. The potential for price appreciation becomes greater in the fourth quarter and into next year, as the yield curve becomes steeper. In my opinion, this anticipated economic recovery and new bull market for stock index futures could be a multiyear event.

Of course that is putting a lot on one indicator especially given the altogether unique nature of this current recession. Many analysts say that equity markets have not yet had the defining capitulation sell-off of the most recent bear market. It does appear, however, that the current correction is nearing a defining moment.

Alan Bush is the senior financial futures analyst at Archer Financial Services, Inc. in Chicago. He can be reached at alan.bush@archerfinancials.com. The views expressed in this article are those of the author and do not reflect the views of Archer Financial Services. Additional research can be found at www.archerfinancials.com

Page 2 of 2
About the Author

Alan Bush is Senior Financial Economist at ADM Investor Services Inc. He focuses on the global macroeconomic outlook and central bank policies and how they impact the price direction for stock index, currencies and interest rate futures markets.​