Trendline Deception

Jeff Miller

Every investor looks at charts. Even those who are not technical analysts check out the captivating image. A chart conveys plenty of information at a single glance.

Then there is the problem of interpretation. At "A Dash" we have tried to do some de-bunking of deceptive charts. A type that is particularly deceptive is the phony trendline.

Interest Rates and the Trend

With the ten-year note approaching a 5% yield, investors are taking note. As a round number, it attracts attention. Some also see some technical significance. The chart below, cited today by Doug Kass in his influential column on StreetInsight (subscription required and worth it for serious investors) shows one interpretation of a long-term trend.

060407_sg430664_t Doug's interpretation, represented by the white trendline, is that a thirty-year trend to lower rates has been broken.

The implication is not clearly stated, but it seems that we are to fear an upside breakout in rates.

Interpreting Trendlines

A trendline based upon a moving average covering a relevant time period can be quite helpful. What about a "trend" that takes two data points, thirty years apart, and suggests some inference?

Our conclusion: Totally bogus!

There are several problems.

* Who cares about the slope from the peak of the high-inflation era in the late 70's to the peak of a year ago? If rates had been a little higher back then, the slope would be steeper. If rates had been a little lower at the peak, it would be more gradual. Use some common sense! What difference does the exact peak thirty years ago have for today's bond prices? None.
* Such charts are extremely subjective. The red line on the chart shows a different trend connecting several peaks. What did that tell us? If you started the chart in the 90's you would have yet another picture -- totally different.
* The conclusion makes no sense. The "trend" suggests that interest rates are going to zero at some point, mostly because of the 70's extreme. That rates would level off at some point is not at all surprising, and did not signal an out-of-control breakout.
* One could pick various other peaks and draw different lines. So what? The result is in the eye of the beholder, and the person drawing the trendline.

Factors Influencing Interest Rates

Barry Ritholtz at the Big Picture had a nice summary of fundamental factors influencing interest rates. The elements include an increase in global rates, strong foreign economies, reduced chances for an imminent Fed rate cut, and a possible move by foreign governments away from U.S. debt instruments. While Barry does not like to acknowledge this, we would add recognition by investors of greater strength in the U.S. economy, shown by all of the second quarter data.

The fundamental factors are important, and interest rates may well move a bit higher. It is an important thing for all investors to watch. We certainly are.

Conclusion

The "stock yield" from forward earnings projections remains much higher than the bond yield, even with bonds hitting 5%. That is part of our thesis for stocks moving much higher in 2007.

Meanwhile, we continue to wait for those who based recession forecasts on the inverted yield curve to draw the intellectual honest and consistent conclusion that recession chances have declined. Readers may wish to watch for this conclusion or whether the recession predictors use some tortured logic to explain why this time is different.

Our conclusion is that the economy is healthy and current interest rates are still supportive of higher stock prices.