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June 15, 2007

Yields May Not Be A Threat Yet
by Chris Ciovacco

With the rising yield of the 10-year Treasury note spooking the markets, it may be worth a historical look vs. the S&P 500. The chart (1962-2007) does show several periods where spikes in the 10-year yield coincided with corrections in the S&P 500 (see the thin black vertical lines). However, the vast majority of the 1982-2000 bull market in U.S. stocks took place during a period where the yield on the 10-year was higher than present level of 5.22% (see green box).

The thick trend lines on the 10-year yield show the long-term take away from the chart. Many have noted that the recent spike in yields broke a 10-year downtrend, which is of long-term importance. However, a 26-year downtrend was broken in 2005 (see red circles) and stocks have done quite well since then.

Envelope Favors Bulls

The trailing PE on the S&P 500 in March of 2000 was 25.5. A quick back of the envelope calculation gives you a March 2000 S&P 500 earnings yield of 3.92%. The 10-year was yielding 6.28% on March 15, 2000. Therefore, the spread was 2.36% in favor of the 10-year Treasury.

As of May 30, 2007, the trailing PE on the S&P 500 was 17.1. The back of the envelope gives us an earnings yield of 5.84%. Therefore, the spread is 0.62% in favor of the S&P 500.

To give us an idea of how crazy inflated markets can get, let's assume the following:

• The yield on the 10-year rises to 6.0%

• Earnings on the S&P 500 stay constant

• We wish to produce the same spread of 2.36% in favor of the 10-year that was present in March of 2000.

The earnings yield on the S&P 500 would have to be 3.64% (6.0% - 2.36%), which implies a PE of 27.47. Under the assumptions, the S&P 500 would have to rise 60% (increase from 17.1 to 27.47) to replicate the spread found in March of 2000.

The purpose of the exercise is not to suggest that stocks are going to rise 60% or anything close to that, but to demonstrate this type of analysis says there is more upside in stocks. It doesn't matter if you agree or disagree with this simple analysis, what matters in the short run is many on Wall Street think this type of analysis matters. My personal perspective is the yield on the 10-year is not high enough to seriously deter stocks from making new highs. I also believe the yield on the 10-year is one of many factors influencing stock prices (meaning this type of analysis is flawed). Rising yields may continue to spook the market for a while, but it should not derail the bull just yet. There are probably more important things to worry about in the short term.

Chris Ciovacco
Ciovacco Capital Management

Chris Ciovacco is the Chief Investment Officer for Ciovacco Capital Management, LLC. More on the web at www.ciovaccocapital.com.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors and tax advisors before making any investment decisions. Opinions expressed in these reports may change without prior notice. This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned. The investments discussed or recommended in this report may be unsuitable for investors depending on their specific investment objectives and financial position. Past performance is not necessarily a guide to future performance. The price or value of the investments to which this report relates, either directly or indirectly, may fall or rise against the interest of investors. All prices and yields contained in this report are subject to change without notice. This information is based on hypothetical assumptions and is intended for illustrative purposes only. THERE ARE NO WARRANTIES, EXPRESSED OR IMPLIED, AS TO ACCURACY, COMPLETENESS, OR RESULTS OBTAINED FROM ANY INFORMATION CONTAINED IN THIS ARTICLE.

Ciovacco Capital Management, LLC is an independent money management firm based in Atlanta, Georgia. CCM helps individual investors and businesses, large & small; achieve improved investment results via research and globally diversified investment portfolios. Since we are a fee-based firm, our only objective is to help you protect and grow your assets. Our long-term, theme-oriented, buy-and-hold approach allows for portfolio rebalancing from time to time to adjust to new opportunities or changing market conditions.

Copyright © 2006-2008 Chris Ciovacco

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