Stock Market Disconnect

During the past ten years, long-term interest rates, the stock market and the US Dollar have generally moved in the same directions. If one focuses on the long-term interest rates, we notice that as rates are rising, the value of the US Dollar and the stock markets are also rising. It makes perfect sense. A strong economy creates additional demand for money and interest rates rise. Foreign investors, seeing higher interest rates and a strong stock market want to participate, causing demand for the dollar to increase.

In the past ten years, the only time we did not really see such a relationship was in 1995. The Dow Jones Industrial Average was marking time at 4,000, a very high level then as 3,500 had provided substantial resistance. Long-term interest rates began falling from the 8 percent level down to 6%. While falling interest rates have generally correlated with a falling stock market, we see the stock market beginning its major "bull" move which ultimately resulted in what some have called a stock market "bubble."

In this instance, it may be that the interest rate move to lower levels was engineered to stimulate the economy and it worked. The Dow rallied from 4,000 to 5,500 and kept on going. However, after this initial thrust, we again see interest rate peaks and valleys coinciding with stock market and dollar peaks and valleys. This relationship has continued to hold until the past summer.

Thirty-year interest rates peaked in May at 5.6%. The Dollar peaked at slightly above 92 on the US Dollar Index, and the Dow reached the 10,500 level. This rally in the Dow fell short of its February peak and indicated a weak divergence. At this point, as interest rates and the dollar began falling, it would be logical to assume that the Dow, which had already shown itself to be weaker than rates and the dollar because of the lower price peak, would also fall. But we did not see this happen.

At the end of the year, 30-year interest rates were testing the year's low at 4.6%, down nearly 18% from 5.6%. The dollar fell nearly 13% to the low of the year 80.39. The Dow, on the other hand, was up to the 10,850 level from the 10,500 levels of April. DISCONNECTED. And why?

In recent months, economic data has shown the economy to be weak. If it weren't for the strong growth in China, there would be little growth in the world. The US has continued to lose jobs and manufacturing has been slow. The only thing positive for the economy is that the low interest rates have enabled homeowners to continually monetize the paper gains in their real estate through favorable refinancing. It's incredible to see that each time a weak economic number comes out and the long-term interest rates plummet, television analysts are all smiles. Isn't it wonderful? Interest rates are lower providing still more refinancing opportunities for the public.

And to see the insatiable demand for ten-year government paper at levels below 4.25% and the 30-year rate at below 4.5% levels, one has to ask, why is there such demand for historically low interest rates? No one is reflecting on the message that falling long-term rates might mean something important. The economy is extremely weak. If this weren't the case, then big money would be selling bonds expecting interest rates to rise. But further analysis indicates that the 30-year bond rate will probably drop to the 4% level or lower this year.

Elliott Wave Theory predicts that the stock market will experience a second corrective wave down. We have seen an incredible stock market move dating back from 1980 when the Dow stood around 765 to recent highs above 11,500. The first corrective wave saw the Dow retrace to the 7,500. While the stock market is now rallying and many indicies and stocks are at all time highs, the Dow average should be at least 10% lower right now if its relationship with interest rates and the Dollar give any real information. I would expect the Dow to be at 9,000. That's the level it was at the last time interest rates were at the 4.48 level in 2003.

Expecting interest rates to make still new lows, the stock market should fall to the 6,500 level and the dollar, which has no real intrinsic value anyway, really has no predictable floor.

My analysis is not meant to panic anyone, only to provide information. Very few talk about a market meltdown. It's not in anyone's interest to tell you that things might go down. After all, most people you hear speaking about the market either are selling products or work for companies that are. While I am not a CTA (Commodity Trading Advisor), I do believe that the futures market provides the best means of participating in market downturns. There are no uptick rules to contend with as in stocks, and it is easy to participate not only in stock market moves, but also the bond market, the dollar and gold. Unfortunately, the public does not participate in the futures markets. The only thing most people know about futures is that they are very dangerous things. Remember Orange County? Remember Barings Bank? Very dangerous, very risky. Avoid them at all costs! Yet I advise serious investors to explore the possibilities that the futures markets provide. Not only do they provide one with a means to easily participate in up and down moves of many different markets, but they also provide risk management options to protect your stock portfolio in adverse times.

Be cautious. Look through the smiling commentators and government officials who claim everything is great. Things really aren't great so avoid being sucked in by this current market move. Although I can't guarantee that the market won't continue to do well and maybe even make new highs, it isn't reflecting reality.