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In the first part of this article Return of the Bear - Part One we looked at secular patterns the stock markets move in and the current state of the Bull Market.

The Monetary Background
I’ve always believed that the “rate-of-change” (ROC) of interest rates is more important than the actual level of interest rates. If levels are so important, how can one explain the extreme economic weakness in the 1930’s when rates were in the basement compared to relative prosperity in the 1970’s and 1980’s when rates were in the stratosphere?

Chart 8. Vertical lines show when ROC crosses above +30, stocks become more risky.

To prove this point, Chart 8 compares the annual change in the level of the Discount Rate to the S&P Composite. The vertical lines show that when the ROC initially moves up to the +30% level, this almost invariably spells trouble for equities. The only exception we can find going back to 1919 is the 1995 experience when equities totally ignored rises in short-term interest rates. The latest signal developed in mid-2004, so even if prices declined from here it could not be regarded as a particularly timely one. However, the main point of this exercise is that it’s still flashing danger for equities, because when rates rise at an exceptionally fast clip, the economy weakens and stocks sell off in anticipation.

Chart 9. Bearish periods highlighted in the light plot. See Chart 9A for more detail.

Chart 9A. Bearish periods highlighted in the light plot.

Another technique you can use is to compare the total return on stocks less the total return on 3-month Commercial Paper to find out when the rise or decline in rates is starting to affect equities. A version of this indicator has been plotted in the middle panel of Chart 9.

A sell signal is given when the indicator moves below zero because it implies the rate of return on cash is about to exceed the rate of return of stocks. The indicator is currently bullish, but is clearly not far from a negative signal.