The Clue to the Stock Market Is the Bond Market

U.S. stocks last week closed at yet another record high while volatility continues to get crushed — nothing to see here folks, move right along. Or is there?

stock market todayIn smart conversations with clients last week, the one question I was asked the most often was what it would take to derail this mother of all stock market rallies. While idiosyncratic risks can pop up at any given time without any notice, the more systemic risks revolve around a change in interest rate environment.

The Federal Reserve as well as other important central banks are slowly but surely shifting from a period of accommodation to a period of tightening, i.e. removing the punch bowl that has allowed such fantastic rallies in stocks over the past eight years or so.

To be clear, this removing of the punch bowl is being well advertised when for example just last month the Fed announced it would begin to slowly shrink its balance sheet starting in October.

I don’t foresee this immediately leading to a crash in stocks yet the upside momentum should begin to slow down in the very near future.

In my opening missive last Monday, I offered the following about 10-year U.S. Treasury Note bond yields — which in my eye are one of the most important vehicles to watch right here right now: “The 10 year yield has many bullish things going for itself, which is to say that a push higher toward 2.60 or higher into year-end looks likely at this juncture. If another push higher in rates does indeed unfold, then this would favor the financial sector and banking stocks.”

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I remain of the opinion that higher interest rates could lead to another round of asset allocation into the financial sector and banking stocks, but I also see this clear shift in interest rate policy to ultimately lead to a much more volatile environment for stocks, bonds, commodities as well as currencies.

The the S&P 500’s SPDR S&P 500 ETF Trust (NYSEARCA:SPY) last week pushed higher still and remains trading at the very upper end of the up-trending range as marked by the two black parallels.

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Moving averages legend: red – 200 day, blue – 100 day, yellow – 50 day

While I wouldn’t chase the SPY ETF higher at this stage, the energy sector of stocks and thus also the price of oil as represented by the United States Oil Fund LP (ETF) (NYSEARCA:USO) continues looking relatively attractive.

In fact, the story of energy stocks and oil is closely linked to that of interest rates, and vice versa. Since the Fed is determined to remain data dependent and is likely to raise rates if inflation picks up, it makes sense to pay close attention to the price of oil.

Why? Because the price of oil is a major part of inflation data and a further rally in oil would thus push up inflation. So, I am closely watching oil and the USO ETF, particularly if the latter were to climb and hold above the $10.70 area a next leg higher could unfold quickly.

In summary, the major stock indices are dramatically overbought in the near-term and while I still see another rally higher into year-end, a pause here would not only be healthy but quite necessary.

In the bigger picture however allocating fresh long-term capital to markets at this juncture in my eye is a low probability trade and in fact profit taking is the structural play I continue to discuss with my clients.

Check out Serge’s Trade of the Day for Oct. 23.

Today’s Trading Landscape

To see a list of the companies reporting earnings today, click here.

For a list of this week’s economic reports due out, click here.

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