Higher Interest Rates and a 1987 Market Redux

If you want to find out what the market is really worried about, just watch the action in the bond market. This is something investors have learned over the years, and it’s why there’s a market adage that says that the bond market is smarter than the stock market. This premise seems to be particularly important to remember right now, as the bond market is telling us interest rates are on the march.

We saw this worry flare-up in earnest in May, when the Federal Reserve’s initial quantitative easing “taper talk” caused an exit from Treasuries and a big spike higher in bond yields, i.e. interest rates. Remember, bond prices and bond yields have an inverse relationship.

After that initial spike in yields on the benchmark 10-year Treasury note, we saw yields pull back in July as the taper talk settled down. Now, however, the market is betting on some form of scale back to the Fed’s $85 billion per month bond-buying scheme, and that’s pushed yields, i.e. long-term interest rates, back to just under multi-year highs.

As we mentioned in last week’s Making Money Alert, if this trend of higher interest rates continues, it will mean a greater cost of borrowing money, and that could lead to a real constriction of economic activity. The Fed doesn’t want this to happen, but if it begins to taper quantitative easing, it may not be able to stop interest rates from being bid up substantially.

Now, the recent trend higher in bond yields and the concomitant concerns over seeing any pullback in the amount of easy money being pumped into the financial system has continued to put pressure on equities. Stocks have come down below their August high, and though I wouldn’t call the recent action a correction just yet, we have seen stocks sputter since the beginning of the month, a trend that can be seen here in the chart of the SPDR DJ Industrial Average (DIA).

One thing to think about here going forward is the chatter out there about the similarities between what’s happened in stocks so far this year and what happened in 1987. During that fateful year, stocks also got off to a rollicking start, but in October, we saw a huge market crash that brought stocks down more than 20% in just one trading session.

Now, I am not predicting a 1987-like smackdown, but what I do think is intriguing is the fact that in 1987, and again in 2013, the market became extremely overbought in August. In August of both years, there were also a diminishing number of stocks hitting new 52-week highs, meaning the number of stocks participating in the wider rally was contracting.

If we continue to see a reduction in the number of companies leading the way higher, it could be a clear sign of a big pullback on the horizon. Maybe not a 1987-like slaughter, but even if the market pulls back by 10%, it’s going to cause a lot of disruption for investors who are overexposed to stocks.