Revisiting the S&P 500 Falling Below 700 Call

On June 1, 2011 I wrote that the S&P 500 may drop below 700. In the article I wrote the following based on my Sagflation theme:

"I believe the stock markets are in for a significant retrenchment based on the deflationary trends of weakening home prices, slowing hiring in a weak employment environment, likely restrictions on fiscal spending, consideration of tightening monetary policy, commodity prices that appear to have peaked, and lack of pricing power by retailers as consumers struggle with debt."

                                                                   - Stock Ideas to Money, June 1, 2011

In the article I also said that I believed the yield on the 10-year treasury may drop to 2% and the yield on the 30-year treasury may drop to 2.5%, suggesting "the place to make money is in treasury bonds as prices rally as investors flood to the safe haven." Since the yield on the 10-year is now below 2% and the yield on the 30-year treasury is around 2.7%, I felt it appropriate to re-visit the article.

One thing I had not anticipated when I wrote the article was the Federal Reserve's Operation Twist. While long-term yields were likely on their way to current levels, in my view, the Fed's announcement likely hastened the move. This week the Fed actually began buying longer duration treasury bonds, likely the primary reason for the fall in 30-year yields yesterday. So I continue to believe yields on the 30-year treasury move down to 2.5%, at which point I plan to further evaluate the position.

Turning to the S&P 500, the index has a long way to fall before dropping below 700. Two points that I have made in the past, but are worth reiterating: (1) the bottom in the stock market most likely does not coincide with the nadir of yields, and (2) on an inflation and cyclically adjusted basis, the valuation of S&P 500 remains above the historical median of 15.8x and well above historical lows in the single digits, which have occurred during extraordinary times. A single-digit PE, as defined by Robert Shiller, would translate to the S&P 500 below 600.

S&P 500 PE Ratio

Source: Robert Shiller, Yale Department of Economics

If 2008/09 is any guide, we can look forward to the following steps:
(1) Capitulation in the markets, defined as record, or near record, volume combined with intraday price swings in excess of 5%. This occurred on October 10, 2008.
(2) Bottoming of the 10-year and 30-year yields. This occurred on December 18, 2008.
(3) Actual stock market bottom, which occurred on March 9, 2009.

Going back to the 30-year treasury yield, if the yield drops below 2.5% before an obvious capitulation day in the equity markets, I may hold the position a little longer.