Bonds swooned today pushing the 10-Year Treasury note to its highest closing level since May 15, 2002. As expected, equities sold off in tandem with bonds (not even Greenspan’s jawboning could save the markets today). As I mentioned in my post June 7th, history suggests that equities could sell off even further given the recent sell-off in bonds.

One of my favorite analysts, Steve Saville , recently wrote an enlightening piece on the relationship between increasing bond yields and equity corrections. In his commentary he writes:

…a downward trend in the bond market will eventually take its toll on the stock market. It’s a question of when, not if, a downward trend in the bond market will drag equities lower. The “when” is typically 5-7 months, but is sometimes as long as 12 months from the start of the bond market’s decline….The current situation is that bonds are about 6 months into a downward trend, so we have entered the time-window when weakness in bonds should be starting to have an adverse effect on the stock market…If the bond market’s decline continues without significant interruption over the next few weeks then a knock-on effect will almost certainly be a sharp stock market correction. (emphasis mine)

He wrote this on June 10th, after the 10-Year Treasury note closed at 5.12% the previous Friday (6/8/10) – a full .23% lower than today’s close.

Mr. Saville goes on to speculate that rising bond yields could end in one of three ways:

1. Bond market rallies pushing rates lower and in line with equities.
2. The stock market corrects over the next couple of months thus keeping equities and bonds inline.
3. The bond market pushes equities into a cyclical bear market.

My clients know that I’m in Camp #3. When your livelihood is wealth management, it is important to assume a prudent attitude towards market participation. This entails determining the odds of a severe market correction and doing my best to protect my clients from losses in equities and bonds. Considering the following factors, i continue to maintain that the odds of a steap market correction are high:

• Currently, we are in the midst (or perhaps end) of the 4th longest bull market in our countries history and the second longest span without a 10% correction.
• Equity valuations are at the high end of their historical range. The P/E ratio for the S&P 500 is in the neighborhood of 17 but if you were to eliminate energy and financials, it would be closer to 20.
• Inflation continues to run hot as energy and food prices measured by the CRB index are up over 15% YTD.
• Housing continues to slump and the dramatic move in rates recently will only serve to push home sales lower.
• The yield on all equity-income products (i.e. Junk bonds, Convertibles, Utility Stocks, REITs, ect.) are just off their historical lows. Given the unusually high correlation of all equity sectors over the past few years, a sell-off in these sectors will be felt by the entire market.

On the technical front, market strength continues to deteriorate providing more evidence that equities are vulnerable to correction. Today, the number of declining issues outnumbered advancing issues by more than a 4:1 margin. The number of stocks hitting 52-week lows was almost twice that of the number hitting 52-week highs. Given that new lows should outnumber new highs on a down day such as this, we are still much closer to the market’s 52 week high then we are to its 52 week low – and for a brief period of time, the S&P index was actually positive today giving stocks a brief chance to hit new highs.

Of course, there are still reasons why this market can proceed higher. Enormous sums of recycled dollars are hitting private equity groups and hedge funds. China alone recently deposited $3B into the coffers at Blackstone Private Equity group – a mere 1% of the total amount of US$’s they are looking to put to work. Our Fed along with Japan’s is still pumping the world’s markets full of liquidity. All markets have been pushed higher by an unprecedented amount of credit and as long as credit is easy, markets could go higher. The next few days will prove interesting. Depending on how the market behaves during the next rally attempt will be very telling as to what the market will do over the next several months.

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