BY Thomas H. Kee Jr.:

Editor, Stock Traders Daily

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(La Jolla, CA)  With Interest Rates playing an integral role in our economic perceptions for 2010, understanding the correlations between the Target Rate and the Market is essential.  In the image below The correlations have been shown.  There are distinct correlations between the Target Rate and the Market, but those are not what normally come to mind.

For example, because higher interest rates often dampen economic activity, one might argue that the Market weakens during increasing rate cycles.  Evidenced by the graph below, that is not the case.  In fact, during tightening cycles, the Market actually performs well.

More specifically, since the Target Rate was established in 1997, the Market has bottom almost exactly when the FOMC stopped reducing rates.  On the other side, the Market has begun to decline aggressively almost exactly when the FOMC began cutting rates.  This is contrary to popular opinion, but the populous is usually not the best judge anyway, as we know.

Before we continue, revisit traditional thinking, and compare it to actual conditions logically.  In normal economic cycles, Interest Rates are increased when the Economy is too strong, and they are cut when the Economy is too weak.  Logically, as investors, we want to buy when the economy is at a peak in strength, and sell when the economy is starting to weaken.  In the graph below, we can see those cycles clearly, and the correlations distinctly. 

Observably over time, the initial reaction is often the wrong reaction.  In other words, if the Market goes down because the FOMC has raised rates, that decline is usually a buying opportunity, not a sell signal.

The vertical red and green lines in the image above represent the 'buy and sell signals' from the FOMC since the Target Rate began.  These are roughly matched to scale, and are intended to relate observations.  The basis for these broad observations is the Dow Jones Industrial Average, often followed by the Diamonds Trust (NYSE: DIA).  However, correlations to The Spiders Trust (NYSE: SPY), representing the S&P 500, and The NASDAQ 100 series trust (NASDAQ: QQQQ) also exist.  The Ultrashort 7-10 year Treasury ETF (NYSE: PST) and The Ultrashort 20 year Treasury ETF (NYSE: TBT) are popular ETFs that react to changes in Interest Rates as well.

Those observations are:

• When the FOMC stops cutting rates, the Market has historically begun to increase

• The Market has historically increased throughout the tightening cycles.

• The Market has begun to decline aggressively when easing cycles began.

• The Market has stopped declining when the FOMC stops cutting rates

• The cycle repeats itself.

In normal economic conditions, this has been true.  Since 1981, the economy has experienced 'normal conditions' according to The Investment Rate.  The Investment Rate is a proprietary leading longer term stock market and economic indicator, and a measure of the rate of change in longer term demand cycles.  It tells us that the normal conditions we have been used to since 1981 no longer exist.  Fundamentally, the economy has changed, and the IR explains why.

With that information in hand, if the Economy is no longer acting in the same fashion as it has since 1981, and more specifically since 1997 when the Target Rate began, will the correlations represented in the graph above continue to exist?

For an answer, review the Investment Rate.  Find a description on the right hand side of most of our pages.

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