A Focus on Yields

Except for the new 30-year bond, U.S. Treasury yields last week lifted by +3 to +6 basis points (bp) from T-Bills through the 10-year Treasury Notes, went higher, And as the yield on the long bond, dropped, the treasury yield curve became even more deeply inverted. So there will be a point soon, I believe, where equities reach a point of no return. Either corporate dividends are raised or equity prices will fall.

Whatever anybody says about the U.S. bond market - and books are being written every day - it is a fact that (i) rising rates, and (ii) the inverting yield curve, combine to tell you that conditions are not right for continued growth of equity prices (as measured by the broad market indexes).

One day in the next quarter or two, there will be a point where the stock market starts to free fall. And equity traders are closely monitoring the bond market, awaiting a day when they feel it might be wise to switch from equity yields to interest yields.

As equity prices are now above 11,000 on a closing weekly basis for the Dow and the S&P 500 at 1289, it is a fact that corporate dividends have to be increased in order to keep the dividend yield competitive with the rising interest yield.

The dividend yield on the S&P 500 (SPX) is now just 1.71 pct, while the 2-year U.S. Treasury Note is yielding 4.71. That +300 bp spread is just too inviting.

Watch for the tipping point.

Given the massive credit balloon in the U.S. and in many other countries, any pullback in the growth of the global money supply will lead to a major recession. There are too many industries from commercial lending banks, to income trusts and REITs, to real estate developers, to oil producers, to retailers, etc, that would suffer immensely.

If, as and when that were to happen, the Bear Market of 2006 would begin. It hasn't yet, but it might be coming up on the horizon.

For U.S. Equities, the past four days (last week included the President's Day holiday) were largely uneventful, except that the small cap stocks rallied into over-bought territory.

U.S. bonds gave up a little more ground last week even though strong inflation data was ignored, and in fact called "benign" and "tame".

Commodities traders were not fooled, as on Friday they jumped on unsettling geopolitical news plus another bump in the weekly money supply data, to push oil and metals prices higher.

Do you find it interesting that these "geopolitical" events (e.g., the attack on the Royal Dutch Shell facilities in Nigeria, and the terrorist attack on the largest Saudi Arabian oil refinery) usually happen soon after commodity price trend support levels hold?

I for one believe that capital markets are often held hostage by political machinery, including terrorists.

Also, in both the U.S. and Canada, inflation was up. U.S. CPI was up +0.7 percent month-over-month, and the talking heads told us "there ain't no inflation". But this silly talk was ignored.

U.S. inflation is now up +4.0 pct Y/Y and for Canada the figure is +2.8 pct (also reported Wed.). These numbers are outside the comfort zone of central bankers in both countries, so rates will continue rising.

So, for Crude Oil, after going up +2.6 percent week-over-week last week, after being up +1.9 percent the prior Friday, the previous weeks' price decline ended at technical support levels, and a rally has ensued.

Gold was up last week due to the price being up +1.7 percent on Friday.

Just like Crude Oil, all trend line support levels for the precious metals held the previous week after extreme weakness early in the month.

Then last Friday the goldminer stocks rallied sharply, up +2.5 percent for the U.S. miners and +1.9 percent for the Canadian miners, saving the week.

On the week, the USD and Euro were flat, but Friday had USD up and Euro down following those geopolitical crises in the Middle East and Africa.

So, clearly, the oil market (and to a lesser extent, the gold market) is on hinges, depending on geopolitical events; but if Crude Oil settles back, then the oil stocks will most likely come down from here, which is why I have been selling into rallies.

But the reason I am still portfolio over-weighted in energy is that: (i) there are some plays (independent oil & gas companies and pipelines) that are promising (in a short-term over-sold market), and (ii) generally I like the sector's corporate cash flow and high dividend yields, particularly on some of the large cap stocks.

In a rising inflation environment, there are two U.S. Exchange Traded Funds (XLB and XLE) to be long, but you have to look at the components. Last week, for instance, as crude oil prices lifted on geopolitical worries, the chemical company stocks got hit (since they have to buy oil to process it into chemicals, and the economy isn't strong enough to pass along the price increases in this particular sector).

So DuPont Chemical (DD) got hammered and so did Lyondell (NYSE: LYO).

When oil prices come down, those share prices will most likely rise. In fact, for a trade, do you see the depth to which the RSI has fallen, particularly on the LYO? This is something you should be looking at.

For the U.S. Industrial sector (XLI is the ETF), the XLI has had a good couple of weeks leading the market up, and, for the past two weeks, Boeing (BA) was the sector leader.

But maybe enough is enough for XLI. The RSI data is looking a little toppy. The key to the U.S. industrial sector, and to the broad market, is to watch the GE share price.

Another note is that January factory durable goods orders in the non-defense industry were down sharply. It was the biggest drop in 5 ½ years. Boeing, for example, sold 204 airplanes in December, but just 39 in January.

Economists will be looking to see if next month continues that way, which could soon become a trend. The multiplier effect then spreads quickly through the economy if that is the case.

And remember, share prices usually precede these economic data figures by 3 to 6 months. When purchasing and sales agents start to see changes at the end of a phone line, they begin to buy and sell stocks accordingly. Then share prices react. It's only months later that the economic data starts to be assembled and reported.

But I started this article by noting that the U.S. Treasury yield curve went more deeply inverted this week. That means the commercial lending operations of banks will be stressed even more, even if the XLF ETF was up strongly last week.

The financials sector is comprised of more than just commercial lenders; there are also insurance companies and brokers, real estate developers, REITs, specialty finance companies, asset managers and broker-dealers, and therein lies the answer to the strength in XLF.

Each of these financial sector industries and sub-industries has unique drivers of revenue and costs. Certainly not all of them are burdened by an inverted yield curve or even by the economic implications of an inverted yield curve, or rising rates. The mergers and acquisitions departments and the bond underwriting departments are prime examples of beneficiaries of the economic conditions that exist today.

Besides, many of these financial companies are thriving in the emerging economies of China and India.

The 2H05 and 1Q06 strength of this financial sector, I must admit, has been a surprise to me. However, I will be shocked if it continues to be strong for the balance of this year.

The only way that would change is for the yield curve to revert to normal, which I don't think is likely for some time.