”History doesn’t repeat itself, but it often rhymes“, Mark Twain
Bob Farrell of Merrill Lynch was rightly considered one of the leading Wall Street analysts in his day. His 10 Rules are still an excellent guide for any investor. Equally helpful is the simple checklist he developed, echoing Mark Twain’s insight, to help investors avoid following the crowd:
He worried that emotion often caused investors to buy at peaks or sell at lows, due to following the herd
He identified how most equity market downturns ended with a 10% annual fall, and major downturns with a 20% fall
He also found that most rallies ended with a 20% gain, and major speculative blowoffs ended after a 40% gain
The above chart applies Farrell’s insight to the US 10-Year Treasury bond market, using Federal Reserve data for the monthly interest rate (NB rates move inversely to the price, so a higher yield means a lower price, and vice versa). We only have to adjust the downside levels, as most downturns end with a 20% fall, and major downturns with a 40% fall.
It is hard to overstate the importance of the 10-Year Bond. It is the benchmark interest rate for the global economy, and so should not suffer speculative blowoffs. In fact, it has only seen 2 blowoffs since 1973 – and both were due to the US Federal Reserve’s recent attempts to manipulate the market:
The first was during the 2008 Financial Crisis, when investors rushed for a “safe haven” after the subprime collapse
The second was after 2011, when the major central banks pushed rates lower during the Eurozone debt crisis
Both were followed by 20%+ falls, confirming Farrell’s Rule 1 – that “markets tend to return to the mean over time”
This suggests that Farrell’s simple checklist is a very powerful tool for an investor who wants to avoid being driven by market fear or greed. It also shows that today’s market is close to blowoff levels, with July seeing a peak after a 35% gain. Another warning of potential stress is that this rally ended with the interest rate at 1.5% – the lowest ever recorded by the Fed (the series goes back to 1953). Is this level really sustainable for a 10-year bond?
If not, the recent rally in the Treasury bond market could have been the last in the series. We may learn more from market reaction to the Fed and Bank of Japan’s meetings this week. Any change in sentiment could have important consequences for Emerging Markets and those in the developed world, as the Financial Times warned recently:
“Institutional investors across the developed world have been pouring money into emerging market assets at a rate of more than $20bn a month since the middle of this year — quite a turnround after the outflows that dominated much of the previous 12 months….the big imperative driving the flows comes from the more than $13tn of bonds in developed markets that now charge investors for the privilege of owning them”.
Investors are so desperate for yield, due to central bank interest rate policy, that they have abandoned their normal caution. Many have invested in countries which they would be hard-pressed to find on a map. Others have bought developed country bonds at higher and higher prices – assuming that interest rates will never, ever, rise again.
Of course, markets can always go higher temporarily. But the logic of Farrell’s Rule 1 suggests that developments in the US 10-Year bond market are warning us that the start of the Great Reckoning is not far away. As the Bank for International Settlements (the central bankers’ bank) warned yesterday:
“Developments in the period under review have highlighted once more just how dependent on central banks markets have become”
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 55%
Naphtha Europe, down 56%. “A build up in products supply has punctured refiners’ margin”
Benzene Europe, down 53%. “Pricing and consumption was expected to see an upturn this month following the lull in activity over the summer holiday period, but this has yet to materialise.”
PTA China, down 41%. “Lack of demand for spot cargoes”
HDPE US export, down 27%. “Exports in July accounted for roughly 23% of PE sales.”
S&P 500 stock market index, up 9%
US$ Index, up 18%