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Bonds & Equities: Expect a Major Shift
By Dian L. Chu, Economic Forecasts & Opinions
The S&P has skyrocketed 58% since its bottom in early March, while the Dow is up 50% and the Nasdaq has surged 68% during that time. Meanwhile, bond prices led a rally as rates on the benchmark 10-year note have declined some 40 basis points since early August. This is good news for business: higher bond prices make it easier to refinance debt and stay in business.
Meanwhile, across the country, Main Street investors are weighing whether they should jump back into the market. However, the price correlation between equities and bonds of late has some argue that typically, if equities are trending higher, then bonds would head lower, and yield would be higher, due to concerns of higher inflation. This essentially describes “the Fed Model”, which is a theory of equity valuation popular among security analysts.
Now, the fact that bonds and equities in general are both firm seems to beg the question - which rally would end first - equities or bonds? This is an intriguing question which I will attempt to examine here.
A split Personality Spells Uncertainty
Based on the Fed Model, bond yields should have an inverse relationship with the stock market in general. We can start by comparing the S&P 500 index (SPX) and the 10-year Treasury notes yield. As displayed in Fig. 1 by the two dotted trend lines, the correlation between stocks and bond yields is time-varying and, on average, negative over the last decade. However, it appears, within the last two years, the negative correlation is more pronounced during the bear phase of the stock market from approximately May 2008 to March 2009 (Fig. 2 green circle).
This simple observation is actually supported by economic research suggesting that the lower expected inflation and the real interest rate is likely to increase the negative correlation between stock prices and bond yields; and that the sharp inverse between stock prices and bond yields in the 1990s bull market can be partially attributed to the lower inflation risk during this period.
The following are some plausible drivers of the current price co-movement between bonds and the equities market:
1. Fast money from Institutional and hedge funds is being allocated to both equities and bonds.
2. Flight from money markets to Treasuries due to the ultra-low interest rates in money markets and massive amounts of cash in the system as a result of the most synchronized global quantitative easing in history.
3. Depreciating US dollar is pushing up everything across the board from commodities, equities as well as bonds.
4. Market’s low expectation of future inflation signaled by the TIP spread of only 1.75%. That is bond market’s 10-year expectation of inflation is now around 1.75%, lower than the inflationary expectations from 2003-2007 of around 2.5%. Low inflation expectation tends to push down bond yields and drive up the equities market.
5. Investors over-react to the “positive assertions” such as Federal Reserve Chairman Ben Bernanke statement that the recession is “likely over.”
Inflation & Interest Rate Expectations
There is often a multi-year lag between the cause (money-supply growth) and the effect (rising prices). So, even though we will probably be in the deflationary phase for the next 12 months or so, once economic growth starts kicking in, we’re bound to experience inflation.
What’s more, the current low inflation expectation of 1.75% is signaling the stock market is most likely mispriced and overvalued right now. Wider recognition of the inflation problem will eventually emerge. Inflation plus a recovery means sooner or later the Fed is going to have to start raising rates.
Higher interest rates and inflation expectations, coupled with the overvaluation in the equity markets could lead to a bear phase and the dreaded W-shape double dip economic scenario. This would mean a major decline in both the stock market and Treasury bond prices (a major rise in bond yields) and borrowing costs for companies will increase exponentially, thus further hindering future growth prospects in the economy.
Expect A Major Correction
The stock market is overvalued and due for a substantial pullback based on any measure of future earnings. Ultimately, bond yields are unsustainable long term, and must rise significantly to pay holders of US Debt for the risk of holding Treasuries against the backdrop of inflated government balance sheets, larger budget deficits, and associated interest expenses on the national debt.
It’s ironic that the takeaway from all this is that both the equities & bond market are mispriced and headed in the opposite direction over the next 24 months. Equities are way overpriced and headed for a major correction (Dow 8,000 level) is a more rational valuation even taking into account improved earnings in 2011.
Expect the 10-year Treasury yield to rise above the 5.25 level in 2011. Increased borrowing costs, a jobless recovery, the collapse of commercial real estate will provide quite a headwind for anyone thinking of making a killing in equities over the next 2 years from the long side.
Bottom Line – Portfolio Repositioning
Start investing in alternative investments like residential real estate, which is where most of the smart money will seek outsized returns, as slowly but surely the favorable long-term demographics start to kick in, as the population increases, excess housing inventory evaporates completely providing for a housing squeeze in 2011. Real estate is actually the best inflation hedge of all, as they call it “Real” for a reason, unlike the US currency.
##I Say Let's Evolve##
Dian L. Chu, Economic Forecasts & Opinions
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Inflation is round the corner? Buy real estate? What have you been drinking?
After the 1929 Crash the equity market fell +/- some rallies on the way down and the bond market rose. Currently the equity market globally looks set for a correction with money moving back into the safe haven of the US bonds and US dollar. This may also drop gold. Given that the US is also intent on dismembering the money market funds, it is quite possible that some of the $3.58 trillion parked there goes into the bond market, reinforcing the fall in bond yields. The charts for many entities are showing signs of negative divergences for those entities that have been up, with the exception of the bond market, and a positive divergence for the US dollar. An equity market correction with a dollar rally and a bond market rise, along with a commodity market fall, would lead to a sudden reversal and a mad panic for the exits. Someone would make a huge amount of money in the process if they were appropriately positioned.
After the 1929 Crash the equity market fell +/- some rallies on the way down and the bond market rose. Currently the equity market globally looks set for a correction with money moving back into the safe haven of the US bonds and US dollar. This may also drop gold. Given that the US is also intent on dismembering the money market funds, it is quite possible that some of the $3.58 trillion parked there goes into the bond market, reinforcing the fall in bond yields. The charts for many entities are showing signs of negative divergences for those entities that have been up, with the exception of the bond market, and a positive divergence for the US dollar. An equity market correction with a dollar rally and a bond market rise, along with a commodity market fall, would lead to a sudden reversal and a mad panic for the exits. Someone would make a huge amount of money in the process if they were appropriately positioned.
Vodka. Buy cases of vodka. When the shit hits the fan, vodka
will go through the roof.
Housing is still way overvalued by any historical measure i.e. price/rent, price/income etc. When Japan's housing bubble burst prices went down every year for 15 years.
Your answer is housing? Seriously?!? WTF. Check the value of your Cisco stock from 2002. Never coming back, and sure as heck not in 2 years. All the smart money says foriegn currencies and equities in companies that don't get paid in dollars. Your million dollar ranch is never coming back sir.
Your comment here hits the mark. Writer is Amerocentric and this is therefore the only way the writer can see the world. Given liquidity going into emerging markets has outpaced domestic markets 5-1, the addition of liquidity to these emerging markets drives markets up.
Off the Wall? Think this fits in but not sure. Counterintuitively, declining population might be good for real physical median net worth, since the planet only has a finite amount of natural resources, and the fewer humans there are on the planet, the larger is the ratio of humans/natural resources. The last few years, Wall Street has been trying to scare the GenXers into abandoning Social Security, telling them that there aren't enough GenXers to give SS checks to the retiring Baby Boomers. Maybe so, but since there are fewer GenXers, there will be more land per human, and therefore more land per Baby Boomer. So let the Baby Boomers grow some of their own food in the backyard, have some chickens, dry laundry out on the clothesline and, generally, rely more on the planet and less on the dollar. Or something like that. Also, the Baby Boomers can then work off some of their obesity pulling weeds and plucking chickens. But they (both the Baby Boomers and the GenXers) will have to fight the Realtors, who in the past did not want anyone doing anything to his house which would keep it from looking like a scale model of an English Lord's mansion. As the Beatles said, in the song Revolution, "You know it's going to be - all right. Doo de doo de doo - all right." :-)
"3. Depreciating US dollar is pushing up everything across the board from commodities, equities as well as bonds."
I see this everywhere. to me, this is approximately equivalent to man made global warming -- everyone says it/believes it but no one thinks through whether it is true.
Follow me here on this logic experiment: US$ depreciates vs. other currencies => US$ priced commodities increase in US$ prices (generally speaking) => US companies' cost of production rises => squeezed profit margins as unlikely to be able to pass through costs to end consumer => reduced earnings growth (possibly to the point of stagnation or reduction) => denominator of P/E ratio shrinks, driving current valuations even higher than they already are (ceterus paribus).
Point being, US$ denominated stocks would have stagnant to falling earnings (in US $ terms), and from a foreigner's perspective, these falling earnings re-patriate into EVEN LOWER local currency later on because $1 of earnings buy's less foreign currency now. so why should stocks rise in a weak dollar environment?
I dispute that the population is increasing. We fixed the hell out of our illegal immigrant problem with our shitbird economy. Western nations have long been declining in natural population... the only thing holding up our population figures is immigration. Well, who wants to move to a place with no job and no future?
I absolutely dispute any population boom sufficient to overcome natural demographic factors in aging babyboomers. That mess isn't going to happen for decades... nor are any new yard apes going to have the accumulated wealth (or as now destroyed wealth) to fill the hole in the former bubble. This is pretty rudimentary.
I would only suggest investing in residential real estate if you can purchase the home for less than its salvage value. It gets cold in the winter, and poor people need wood for their burning barrels.
Good report and summation. You wrote: The stock market is overvalued and due for a substantial pullback based on any measure of future earnings. Ultimately, bond yields are unsustainable long term, and must rise significantly to pay holders of US Debt for the risk of holding Treasuries against the backdrop of inflated government balance sheets, larger budget deficits, and associated interest expenses on the national debt. In the very short term (1-3 months), if stocks sell off, we're looking for treasuries to find a bid on an inverse safe-haven trade possibly up to 123-125 area (though they'll need to take out ST stops above 121.07-13 area and above first, dating back to early July). In closing, equity market and the what happens to the dollar will be key to any of these scanarios. Good luck.
As warned about earlier - VIX, Copper, USD have been giving warnings signals for a while.
LATEST MARKET OUTLOOK:
http://www.zerohedge.com/forums/zero-hedge-forums/equity-forum
not to mention they keep building more.
I think most if not all reductions reported in inventory are sellers who have just given up.
There is also the factor of banks not even listing foreclosures because of the impossibility of selling.....ala the wells fargo party mansion
"Meanwhile, bond prices led a rally as rates on the benchmark 10-year note have declined some 40 basis points since early August. This is good news for business: higher bond prices make it easier to refinance debt and stay in business"
Fascinating.
Imagine that a business wants/needs deleveraging. This requires pending debt cancellation or, put another way, repurchase in market part of its outstanding bonds.
Is glad that business that its own bonds rise in price? Or, put another way, If a rise in bond prices benefits the lender can also benefit the debtor who is the counterpart in this business?
Or, put another way, can a old business that carries old high rates debt to compete with new businesses that can be financed at low rates?
Or, put another way, does ultraexpansive suicide zero interest rate monetary policy, strengthens or destroys the capital of a nation?
Some analysts seem to think only in terms of which a company must leverage and grow and never think about what happens when companies need to tighten or deleveraging. Keynesian pure garbage.
It's grow or die . . . until it's shrink or die. It's the motion in the ocean that never stops.
the economy with all of its markets massively manipulated by the government is a giant rorschach test and this interpretation is no better...it's voodoo economics on qualudes....
the only point with which i can agree is that everything is mispriced due to artificial and massive quantities of money available....
it would have helped to evaluate prices in real terms and in terms of gold but even the gold market is manipulated so i am not sure how helpful that would be.....
pricing analysis done in nominal terms over large time periods ( >24 mo) is a waste of time....
until a complete crisis has occurred which ends all market interventions we have no idea where we are going...
It seems to me that almost all asset classes are likely to correct downward vs the dollar in a deflationary environment. If deflation is present then it is likely to persist for some time yet with the result that the dollar appreciates vs stocks, houses, commodities & precious metals. So its only if you are persuaded by the inflationary argument then real estate makes sense, otherwise remain in cash.
Thank you, and I disagree on the real estate. After their jobs got shipped to Mexico, Japan, China, East Timor, Honduras, India, ad nauseum, how will blue-collar Americans make enough money to buy those $200,000 or $300,000 nano-mansions? We are at the exact result that Ross Perot warned us we would get to. So what happens now? Maybe a lot of the presently empty houses just sit empty. Maybe, sooner or later, the owners of those houses give up and sell them for $100,000, which might be an affordable price for many American blue-collar one-income families. It would seem that those owning those empty houses should be focusing their efforts on getting the manufacturing brought back to America. But that might hurt their pride, since it seems that, for some reason I never understood, American landlords seem to consider themselves different from and smarter and better than American working people and, indeed, often seem to despise those working people. Would it be easier if we said that Ross Perot was right AND THEREFORE AL GORE WAS WRONG, when he argued against Ross on this question a nationally-televised debate in 2000?
In my area there are many vacant houses, the banks have 3 years until they come up on tax sales. They surely don't want to liquidate property and hurt the books. There will also be excess real estate available due to mortality.
In my area there are many vacant houses, the banks have 3 years until they come up on tax sales. They surely don't want to liquidate property and hurt the books. There will also be excess real estate available due to mortality.
We're going to 10,334 first. I hate to admit it but this dip is being ferociously purchased. Nothing goes straight up.
We have to get through the psychological 10,000 level before Christmas at any expense. Sure, it is like taking ecstasy but 10,000 is the make-break point for small businesses to get that 2010 feel-good feeling, start hiring again and making deals. Your research is very impressive but that only takes into consideration the past. It doesn't factor into the equation any human decision that could be made into the future. There is an invisible impetous guiding this market up to and through 10,000. The FED still has an arsenal of tools they could use. Every short (including mine) got blasted apart. Still too dangerous to short (except for today and yesterday which was obvious of course). Its not about the market, and its not about the impressive research. What is at stake is whether or not we sink back into the dark ages again. Any shoe repairmen here? Silversmiths? Lumberjacks? Sure the economy is frozen solid (just like post 9-11). This is some freaky stuff. But people have to be motivated to engage, enterprise and produce again. Small businesses are the way out. 10,000 Dow gets us there (actually the resultant deli chat people have with strangers will when the Newspaper headlines start reporting DOW 10,000!!!!) People will begin to enterprise again, hire and engage even if subconsciously. It took a while to understand how/why "confidence" can be manufactured albeit a gold reserve is much nicer.
The technicals and fundamentals DO NOT MATTER. Just like life support doesn't matter to a banged up patient with the desire to live. Americans have that desire and the bailout protests in DC, at the G20 are all indicitive of that despite their abberations.
What matters is confidence and if that can't be backed up by Gold and Silver it will contine to be drug induced (more backstops) until people buy, deflation is stopped, and the cogwheels of the economy start cranking. There is just no other way and no other choice despite Joe Terranova's conviction that "the training wheels are coming off" (Yeah, right).
The decision has been made and there is no giving up or stopping now. The FED can always find ways to stimulate the economy. If stimulus packages can be no more due to public outcry don't be surprised if the US income tax is waived for 1,2,3, 5? years for small businesses or individuals (far fetched I know, but that is the tool of last resort and probably the most effective).
Waiving federal income taxes for small businesses or individuals would be the ultimate game changer to naturally launch an inspirational recovery which would come from the people , not the government - OH the Irony.
Cheap Oil is helpful but psychologically it is not helpful if US citizens (who know BRIC are emerging oil consumers) think $4 gas is just around the corner. So it is not considered a tax credit at all by the common man. OPEC wants $75 oil and we are almost there (nationalized oil).
If you can't inspire small businesses and consumers with tax credits (their last resort) we could be toast. I used to make (net) 500K a year running my own businesses. Then I bought a Prius, rented out my 800K (now 500K) house and that is still not enough deleveraging. I'm ready to move to Brazil by March if Dow 10,000 doesn't dent unemployment or show promise and come back in 2000 and never.
I'll build my own little village on a beautiful beach. "F" the US if DOW 10,000 and tax cuts don't change conditions here by March. I'm not waiting any longer.
Long Island NY
www.itacare.com
DPK above 16.61?
http://stockcharts.com/def/servlet/Favorites.CServlet?obj=ID3251493
Last I read there was a huge overhang in housing, something like 4-5 years to pump this through the system, how can there possibly be a squeeze by 2011 with this many units and probably more to come?
exactly, demographic factors lead to only one conclusion on housing, that babyboomers are net sellers of housing and will contribute to the supply. Further, as families become even more economically depressed, you're going to get multiple families moving into single homes (or multiple family members consolidating into a single home). You also get bargain purchasers who buy up the mcmansions and essentially make a frat house out of it, leasing it to as many people as there are bedrooms and couches. (if they say they want to take you to the roof, don't do it, they're gonna tie a brick on your pee pee).
Aside from the fact that foreclosures are ramping... and a jobless recovery dictates further falls in housing prices...
no deflation? seems like we have deflation, prices are domestically falling? stopping deflation is like pushing on a string.
That will be hotly debated for a while. I say that 2007-2008 there was so much liquidity that it allowed many bubbles. Housing bubble, commodities bubble, stock market bubble. There was inflation in those markets mainly BUT producers costs of goods also rose. But cheap money kept that from causing massive inflation. Then something happened and poof it all burst. Producer costs plummeted, AND there was a massive reduction in purchasing, consumption, inventories. Then we had a liquidity crises. The FED and the federal government pushed trillions out there and it didn't help much. That's a liquidity trap. People sopped up the cash and sat on it. That is what deflation does. So they keep pumping out more and more money.
OK maybe this is too rudimentary but the debate rages. There are those who say inflation is going to be massive. Well, we had massive inflation in asset classes up through 2007. We might have massive inflation later. OR maybe there are more places to sop up all this cash. Chinese are buying mines in Africa. That is a win win win - they sop up the liquidity, prevent a dollar crash (to some extent), they help progress in Africa, and they own hard assets and natural resources they can use and later sell. Amazingly we can print all this money and, possibly, mitigate the inflationary risk in such ways.
Many people say they worry about inflation but I still think most of those same people would prefer to have cash. I, a producer, would prefer to have cash right now than anything else I could reasonably have. I don't want land, I don't want inventory per se, I don't want stocks and i don't want bonds. I want cash. I still fear a LACK of liquidity. Maybe I am wrong, or misguided. But right now it is what I believe. With cash I can buy inventory (and very few producers are building inventories - they are doing most everything made to order or massive turns of inventory (thin layers of inventory)). This is because credit is too tight, and liquidity remains mysterious if not thin as well.
I felt the same way about cash, until I read that the guarantee of the money market funds came off on 9/18 and that the Fed is discussing entering into reverse repos with the money markets, swapping cash for their junk. Isn't holding junk exactly what broke the buck in Reserve a year ago? On top of that, you've got the Fed/Treasury failing to support the slide in the dollar and there seems to be no safe place to hold wealth.
Well that sucks. I guess I need a bigger mattress. :-)
in fig 2, it looks like yields and stocks are positively correlated. nevertheless, the same conclusion where both stocks and bonds fall in value.
The notion that possibly the largest asset bubble in our lifetimes will revived in two years from now sounds extremely counterintuitive to me. There can be no housing revival without credit creation, and my take remains that the years to come are going to be characterized by very weak credit creation.
On bonds, I do expect them to continue to perform (a point already made by my man Andy Dufresne) because as much as the supply scares the shit out of everybody, the point above means that growth will suck monkey balls for the foreseeable future, and gov paper will crowd out other forms of investments.
The Japanese proxy has been over-used, but when the cohorts of boomers will shift their secular focus from capital gains to income, Treasury paper will come in handy.
Still expect the Q4 08 lows in yields to be challenged.
Makes sense to me. Expect to be humming "TBT uber alles" in a year or less!
Thanks ... nice clear reasoning.
Residential real estate != alternatives...IMO
like the call on 10yr UST though
DRV above 16.23?
http://stockcharts.com/def/servlet/Favorites.CServlet?obj=ID3251493