The three steps and a stumble rule
Another manifestation of the relationship between interest rates and stocks is the
so-called "three-steps-and-a-stumble rule." This rule states that when the Federal
Reserve Board raises the discount rate three times in succession, a bear market in
stocks usually follows. In the 12 times that the Fed pursued this policy in the past 70
years, a bear market in stocks followed each time. In the two-year period from 1987
to 1989, the Fed raised the discount rate three times in succession, activating the
"three-steps-and-a-stumble rule" and, in doing so, placed the seven-year bull market
in equities in jeopardy (see Figure 4.10).
FIGURE 4.10
AN EXAMPLE OF THE "THREE STEPS AND A STUMBLE" RULE. SINCE 1987, THE FEDERAL RESERVE
BOARD HAS RAISED THE DISCOUNT RATE THREE TIMES IN SUCCESSION. HISTORICALLY,
SUCH ACTION BY THE FED HAS PROVEN TO BE BEARISH FOR STOCKS.
Changing the discount rate is usually the last weapon the Fed uses and usually lags behind market forces. Such Fed action often occurs after the markets have begun to move in a similar direction. In other words the raising of the discount rate generally occurs after a rise in short-term money rates, which is signalled by a decline in the T-bill futures market. Lowering of the discount rate is usually preceded by a rise in T-bill futures. So, for a variety of reasons, short-term futures should be watched closely.
It's not always necessary that the bond and stock markets trend in the same direction. What's most important is that they don't trend in opposite directions. In other words if a bond market decline begins to level off, that stability might be enough to push stock prices higher. A severe bond market selloff might not actually push stock prices lower but might stall the stock market advance. It's important to realize that the two markets may not always move in lockstep. However, it's rare when the impact of the bond market on the stock market is nonexistent. In the end it's up to the judgment of the technical analyst to determine whether an important trend change is taking place in the bond market and what impact that trend change might have on the stock market.
HISTORICAL PERSPECTIVE
Most of the focus of this study has been on the market events of the past 15 years. It
would be natural to ask at this point if these intermarket comparisons hold up over a
longer span of time. This brings us to a critical question. How far back in history can
or should the markets be researched for intermarket comparisons? Prior to 1970 we
had fixed exchange rates. Movements in the U.S. dollar and foreign currencies simply
didn't exist. Gold was set at a fixed price and couldn't be owned by Americans.
The price of oil was regulated. All of these markets are critical ingredients in the
intermarket picture.
There were no futures markets in currencies, gold, oil, or Treasury bonds. Stock
index futures and program trading hadn't been invented. The instant communication
between markets that is so common today was still in the future. Globalization was
an idea whose time hadn't yet come, and most market analysts were unaware of
the overseas markets. Computers didn't exist to permit study of interrelationships.
Technical analysis, which is the basis for intermarket work, was still practiced behind
closed doors. In other words, a lot has changed in the last two decades.
What needs to be determined is whether or not these developments have changed
the way the markets interact with each other. If so, then comparisons prior to 1970
may not be helpful.
THE ROLE OF THE BUSINESS CYCLE
Understanding the economic rationale that binds commodities, bonds, and the stock
market requires some discussion of the business cycle and what happens during periods
of expansion and recession. For example, the bond market is considered an
excellent leading indicator of the U.S. economy. A rising bond market presages economic
strength. A weak bond market usually provides a leading indication of an
economic downturn (although the lead times can be quite long). The stock market
benefits from economic expansion and weakens during times of economic recession.
Both bonds and stocks are considered leading indicators of the economy. They usually turn down prior to a recession and bottom out after the economy is well into a recession. However, turns in the bond market usually occur first. Going back through the last 80 years, every major downturn in the stock market has either come after or at the same time as a major downturn in the bond market. During the last six recessions bonds have bottomed out an average of almost four months prior to bottoms in the stock market. During the postwar era stocks have begun to turn down an average of six months prior to the onset of a recession and have begun to turn up about six months prior to the end of a recession.
Tops in the bond market, which usually give earlier warnings of an impending recession, are generally associated with rising commodity markets. Conversely, during a recession falling commodity markets are usually associated with a bottom in the bond market. Therefore, movements in the commodity markets also play an important role in the analysis of bonds and stocks. The economic background of these intermarket relationships will be discussed in more depth in Chapter 13.
WHAT ABOUT THE DOLLAR?
Discussions so far have turned on the how the commodity markets affect the bond
market and how the bond market affects stocks. The activity in the U.S. dollar plays
an important role in the intermarket picture as well. Most market participants would
agree with the general statement that a rising dollar is bullish for bonds and stocks
and that a falling dollar is bearish for bonds and stocks. However, it's not as simple
as that. The U.S. dollar hit a major top in 1985 and dropped all the way to January
1988. For a large part of that time, bonds and stocks rose as the dollar weakened.
Clearly, there must be something missing in this analysis.
The impact of the dollar on the bond and the stock markets is not a direct one but an indirect one. The impact of the dollar on bonds and stocks must be understood from the standpoint of the dollar's impact on inflation, which brings us back to the commodity markets. To fully understand how a falling dollar can be bullish for bonds and stocks, one must look to the commodity markets for answers. This will be the subject of Chapter 5.
SUMMARY
This chapter discussed the strong link between Treasury bonds and equities. A rising
bond market is considered bullish for stocks; a falling bond market is considered bearish. However, there are some qualifiers. Although a falling bond market is almost
always bearish for equities, a rising bond market does not ensure a strong equity
market. Deteriorating corporate earnings during an economic slowdown may overshadow
the positive effect of a rising bond market (and falling interest rates). While a
rising bond market doesn't guarantee a bull market in stocks, a bull market in stocks
is unlikely without a rising bond market.