Why the Performance Differential Between Treasury Bonds & the S&P 500 Matters

The wild and manic year of 2011 is finally starting to wind down as 2012 rapidly approaches. Market participants are waiting to see if Santa shows up with a present or a lump of coal for Wall Street this year. Performance anxiety is becoming apparent as professional money managers are running out of time to meet their stated benchmark performance.

Hyper-beta stocks such as AAPL and GOOG are likely to be well bid as money managers will chase Beta into year end if prices grind higher. This time of year volume generally dries up and volatility comes out of the marketplace giving the bulls a slight edge in terms of short term price action. While I expect some choppy price action the next two weeks, I believe strongly that we are at a major inflection point.

There are potential warning signs showing up in guidance reductions that seemingly continue to come out. Semiconductors as well as industries which are exposed to emerging markets seem to be indicating that economic conditions may be worsening as a result of the fiscal issues stemming from Europe and a possible slow down in emerging market economies like China.

Just as the end of the year usually leads to light volume drifts higher, it also produces predictions from economists, traders, and famous market prognosticators. No worries, I am not about to produce a list of my predictions as I think it is a futile endeavor. However, I want to point out a divergence in price action in 2011 that continues to defy what most market professionals would have expected in 2011.

The divergence is not some fancy proprietary indicator, but the performance differentials of the S&P 500 Index and 30 Year Treasury bonds. The table below, courtesy of Morningstar illustrates the performance of Treasury bonds year to date as of Friday’s close:

As can be seen above, the Long-Term U.S. Government Bond has returned 23.16% in 2011. Back in January of 2011 had I been informed that as of the close on December 16, 2011 30 Year Treasury Bonds would have returned more than 20% to investors I would have been shocked. Furthermore, I would have expected U.S. equities to have been pounded lower. Treasuries truly have rallied, but the S&P 500 was only trading 3% lower for the year as of the close on December 16th. So what does this divergence mean?

Obviously astute readers would point out that the Federal Reserve’s monetary policies have had a major impact on Treasury prices and I do not disagree. However, the divergence is remarkable in that either equities are extremely overvalued or Treasuries are overvalued going into 2012. From a long-term technical standpoint, the price action in both underlying assets reveals that we are truly at a major inflection point and the near term price direction will give us clues. The daily chart of the S&P 500 and the weekly chart of the 30-Year Treasury Bond are shown below:

S&P 500 Daily Chart

As can be seen above, a smaller wedge broke down back in November which resulted in a loss of roughly 80 S&P handles in a matter of a few weeks. The price pattern on the daily chart is now in an even larger wedge formation. This type of formation stores significant amounts of “market energy” which will result in a significant move in the price action when a breakdown or a breakout occurs.

30-Year Treasury Bond Weekly Chart

The 30-Year Treasury Bond is on the verge of breaking out to new all time highs as early as this week. The flip side of the bullish argument is that price will fail carving out a double top and sending Treasury prices considerably lower. The S&P 500 is trading in a triangle on the daily chart and the 30 Year Treasury Bond is on the verge of breaking out to the upside. Typically cycles break with the news and I expect a major announcement to take place in coming days / weeks that will enlighten us as to whether the S&P 500 or long term government bonds are expensive.

Clearly Europe will have a major impact on which direction price action ultimately breaks for both Treasury Bonds and the S&P 500. Fourth quarter earnings and final gross domestic product numbers will also be quite telling as to the strength of the marketplace. However, the U.S. Dollar and the Federal Reserve’s forward monetary policy in 2012 will likely seal the fate for both government bonds and equities.

My contention is that the Federal Reserve may find themselves in quite a predicament which may not have a positive long term outcome for the United States regardless of their decision. If Europe starts to fall apart, I will be shocked if the Federal Reserve does not come out with QE III.

The implication of QE III could be quite severe and could cause the Dollar to fall off of a cliff. The Federal Reserve would rather have inflation than deflation, that is without debate. If Europe starts to falter, deflation will become the buzz word and the Federal Reserve will likely act.

If Europe starts to break down and the Federal Reserve does nothing I expect to see a major selloff in risk assets as money will pour into the short term safety and liquidity of U.S. Dollars and Treasuries.

If the Fed initiates QE III, risk assets will rally sharply as gold, silver, oil, and the S&P 500 will benefit. Commodities will enter their final bubble while the S&P 500 eventually would break down violently as interest rates and higher commodity prices hammer the economic cycle.

The daily chart of the U.S. Dollar Index and the Reuters/Jefferies CRB Commodity Index are shown below:

U.S. Dollar Daily Chart

The U.S. Dollar is trading in a consolidation zone near the recent highs. In addition, the U.S. Dollar Index has traced out a rising wedge pattern which could ultimately break in either direction and reinforces that a major inflection point is upon us.

A pullback that tests the lower support level seems likely based on seasonality. These charts are all indicative that something is brewing in the early part of 2012 which may result in major moves in a variety of underlying asset classes.

Reuters/Jefferies Commodity Index Daily Chart

The CRB Index is trading right at key support. Price action could form a double bottom and bounce higher to test the descending resistance line shown above. I would point out the oversold nature of the CRB Index presently. A bounce appears likely, the question is whether price will be able to push through resistance.

A bounce may work off oversold conditions and allow for a major retest of the October 2011 lows. It is not an accident that major underlying asset classes are all coiled up in what is going to be a major move in the early part of 2012. The stage is set, the only question is which outcome and price direction occurs.

I would point out that the Dollar is trading in a tight consolidation zone presently and could break in either direction while the Commodity Index could either be putting in a double bottom (bullish) or possibly could breakdown to new lows. The stage is set for 2012, the question is which direction Mr. Market will choose?

I do not have an opinion at this point in time as to how this situation will finally be resolved. I plan on monitoring the price action while waiting patiently for breakouts in either direction to be confirmed. Europe and the U.S. Dollar are going to be critical in 2012, that is obvious.

We are presently at a major inflection point and frankly whether Santa Claus comes to Wall Street in 2011 is not nearly as important as what happens in the 1st Quarter of 2012 as all of these charts will likely see some form of resolution. Be careful out there.

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JW Jones


This material should not be considered investment advice. J.W. Jones is not a registered investment advisor. Under no circumstances should any content from this article or the OptionsTradingSignals.com website be used or interpreted as a recommendation to buy or sell any type of security or commodity contract. This material is not a solicitation for a trading approach to financial markets. Any investment decisions must in all cases be made by the reader or by his or her registered investment advisor. This information is for educational purposes only.