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MarketWatch
By Mark D. Cook
3 hrs ago
Jin Lee/Bloomberg/Getty Images Traders work on the floor of the New York Stock Exchange (NYSE) in New York on Monday, Aug. 11, 2014. Jin Lee/Bloomberg/Getty Images
The stock market has an empirical rule: interest rates lead stocks. And the current interest rate environment is pointing to a massive decline for the U.S. market.
Consider: The Federal Reserve has taken rates to the lowest level in more than a generation. This has energized stock prices. The Fed has persisted in its directive to “stay the course,” having made no raises in the discount rate for more than seven years. Such monetary policy has no precedent; this is the longest stretch of accommodation by the Fed in the post-World War II era.
But there’s Fed-induced rates, and “actual” rates. The most widely followed Treasury markets are the longer-term 10-year and 30-year markets. These two markets are highly sensitive to longer-term actual interest-rate pressures. For example, banks use longer-term Treasurys to make decisions on pegging personal loan rates to clients for mortgages, businesses, and other uses. The commercial and industrial areas of the economy also are susceptible to the actual cost of money.
Are there parallels to this current market environment? Yes — 1987.
The summer that year began with a slow, methodical rise in actual rates. Yet the Fed did not raise the discount rate, even though actual rates suggested otherwise. The fall of 1987 arrived with the stock market having hit an all-time high in late August, unfazed by this unsettled condition.
As it happened, the Federal Reserve was literally forced to raise interest rates. Policymakers were behind the curve severely, just as the Fed is now. The 1987 rising-rate action caused stock prices to tumble more than 30% within two months, including a sharp 20% selloff in October — still among the Dow Jones Industrial Average’s worst one-day percentage declines ever.
Get ready for a 4,000-point Dow drop ? © Provided by MarketWatch Get ready for a 4,000-point Dow drop
These warning signs are again visible. The first week of June recorded the highest interest rates since December. Bond prices are down about 12% since the end of January.
The stock market, meanwhile, follows the bond market’s direction — except by a much wider margin. A multiple of 2.0 is conservative. A 2x multiplier figured against the recent 12% plus loss in bonds prices would generate a 24% decline in stock prices.
At current levels, such a slide would equate to a loss of about 500 points on the S&P 500 and a Dow pullback of close to 4,300 points.
So pay attention to rising actual rates. The “actual” bond market is already into a bear market, with declining tops and lower lows since the end of January. The stock market is vulnerable here. The first week of June saw interest rates spike, with bond prices losing 2.5% of their value. This is comparable to around a 7 1/2% loss in stock prices in one week.
The pressures are increasing exponentially since the decline in bond prices has not resulted in a stock market slide. And the greater the pressure, the greater and quicker will be the downward move.
Mark D. Cook (www.markdcook.com) runs The Mark D. Cook Advisory Service for investors and traders.
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