Stocks May Revive as Funds Exit Bonds

Monday saw a stunning move in the U.S. Treasury market that had a lot of folks paying close attention. The benchmark 10-year Treasury yield, which sets the course for everything from mortgage rates to car and business loans, declined from above 4.025 percent to close the day at 3.85, an astonishing drop of over 4 percent.

That’s the kind of selloff we usually see in a volatile sector like gold or crude oil—not go-slow bonds. The decline capped a four-month fall in the 10-year yield from above 5.2 percent that started in the midst of the subprime meltdown last summer.

Meanwhile, bond prices, which trade opposite to the yield, have catapulted up, up and away. All this has been great for bondholders and, potentially, for reviving the markets and economy, as falling interest rates are wont to do. But it also signals the market’s deep preoccupation with the weakness provoked by the housing disaster, which caused a lot of money to flow out of stocks and into safe-haven bonds.

Now there’s comes a sign of a possible new direction for the bond market, which could in turn have big impacts on stocks and commodities. The latest Commitments of Traders report issued by the U.S. Commodity Futures Trading Commission suggests that small traders in the 10-year Treasury note have hit the brakes and suddenly ramped up their net short position in 10-year futures and options. (The 10-year Treasury is tradable with iShares Lehman 7-10 Year Treasury (IEF) and SPDR Lehman Intermediate Term Treasury (ITE).)

I’ve developed a trading setup based on following what the small traders are doing in the Treasury market. Historically, they tend to be correctly positioned at tops and bottoms in the 10-year yield. (I know it’s strange. Normally, the small traders are considered to be the “dumb money.” But my research has found that’s not true in every market!)

My trading signal flipped to bullish with the July 31 COTs report, but it has now just flipped back to bearish with the latest COTs report issued Monday, Nov. 26. This means the “smart money” believes the 10-year yield has bottomed and will now start climbing again. (That’s bearish for the Treasury note’s price.)

Meanwhile, all my other Treasuries trading setups based on the Commitments of Traders reports remain in bullish mode. That includes the entire yield curve, from the 30-year Treasury bond (tradable with iShares Lehman 20+ Year Treasury (TLT) or the SPDR Lehman Long Term Treasury (TLO)) on down to the 30-day Fed Funds contract (tradable with SPDR Lehman 1-3 Month T-Bill (BIL)).

So what does this all mean? I think the overall COTs data suggests that interest rates may not decline much further at this point (and that bond prices may soon top).

It could be a sign that money will start to flow out of high-flying bonds and back into stocks and commodities—and that the markets generally believe things are looking up.

A confirming sign of that comes from my COTs U.S. Composite Equity Index, which is based on the COTs data for the S&P 500, NASDAQ 100, Russell 2000 and Dow Jones industrials. The latest COTs report issued Nov. 26 has moved this index up smartly to 0.62, from the previous week’s 0.04. The index has been on a bullish signal since March 27, but it turned decidedly down in late September, warning of coming market trouble.

Now, it’s revived nicely and has given me a renewed bullish signal for my trading setup for the S&P 500 (tradable with S&P 500 SPDR (SPY), S&P 500 iShares (IVV) or the 200-percent leveraged Ultra ProShares S&P 500 Fund (SSO)).