What Are The Markets Trying To Tell Us?
**Since March 2010, Mr. Bernstein has served as Senior Vice President, Research, for AH Lisanti Capital Growth, LLC, a registered investment adviser. This commentary solely represents Mr. Bernstein’s views and opinions as of July 21st, 2010, does not constitute investment advice and does not depict the views of AH Lisanti Capital Growth, LLC.
Action in the bond, stock and commodities markets have been very confusing to me as of late. The stock market, which has broken critical technical levels (see my recent piece "Critical Juncture") has "hung in there" recently, partly due to the extremely bearish sentiment of investors, who typically "get it wrong" as a group in the short-term.
But much more perplexing to me than the stock market's refusal to completely barf over the stream of negative macro economic data points and poor technical action, is the lack of spread widening in the bond market in the face of plummeting bond yields. I know I'm talking "inside baseball", so let's back up and define some terms.
Risk spreads are the premiums demanded by bond buyers above the "risk free rate" (embodied by short-term US treasury rates - peanut gallery please refrain from Uncle Sam is broke jokes) in order to be persuaded to hold bonds with some non-zero risk of default. When bond investors get nervous about bond issuers ability to pay back their debts (weakening economy and/or liquidity crisis) these spreads (yield differentials) tend to "blow out" (widen). Shockingly, while bond yields are "breaking down like a soup sandwich" lately (their prices are surging and yields falling, indicating inflation pressures in retreat), riskier bonds are rallying almost as much, keeping spreads in check. As you can see from the chart below, which I borrowed from the Bank Credit Analyst, bond spreads have not blown out during the recent treasury rally. This is likely explained by the new peak in return on capital being reached by corporations (as their returns on investment are far eclipsing their cost of capital). This large spread is a cushion to corporations' abilities to support their debt, even if sales and/or profit margins were to contract to some degree.
Many investors believe that the bond market is less flighty and more rational than the stock market, particularly in light of the bond market's sniffing out the world financial crisis before the stock market did. For this reason I take the strange behavior being exhibited by bond spreads seriously. If one were to assume a less omniscient bond market, one could explain the current situation thusly: Investors are worried about deflation and are piling out of stocks and into bonds, they are also blindly buying credit risk in a desperate grab for yield. The expectation would be that eventually the slow economy would punish the yield seeking buyers by haircutting their bond prices (raising yields) and blowing out spreads versus treasuries.
But what if bond buyers are actually very smart and rational? What if they actually believe that the economy will slow, unemployment will remain high and inflation will not be a problem for a long time? What is they also believe that this does will not result in a slow down bad enough to cause bond defaults, maybe just earnings disappointments? Then bonds rallying across the risk spectrum would make sense. Interestingly, I believe that the recent action in gold prices is expressing belief in the same theory.
Gold has been a one way bet for the last couple of years. It has seemed to be "insurance" against two tail risks (unlikely but highly damaging occurances). In the first case, the market imagines that the economy stabilizes and begins to turn around and all of the bank reserves that have been stashed away and creating no economic growth because they are not being lent out, come rushing back into the market too rapidly for the Fed to mop them up, creating an economic overheating and inflation. In this case gold would participate in the inflation trend. On the other side of the coin, what if the economy went into a deflationary tailspin and the only way for the U.S. to pay of it's debts was to allow the dollar to crash, print money and devalue our way out from under our debt. In this case our cheapened dollars would barely buy anything, causing the hyper-inflation seen in undisciplined emerging economies in the past (think Argentina a few years ago). Gold would certainly retain its value and explode to the upside in a relative sense, under such a scenario. Recently, however, gold has tended to be more and more correlated to a rising stock market, and has felt more like a momentum driven risk play. As such, it has grown "tired" as the stock market has rounded over and churned. Click (View image) to see a gold chart which appears to be potentially topping out (note that during gold's multi-year run, it has had corrections of this duration and magnitude before and later moved on to new highs, although these seemed to follow more parabolic rises than the recent run.)
I like the self consistent picture that seems to be being painted by stocks, bonds and gold right now. In short, the action of all three assets suggests that the economy is slowing....enough to dent corprate earnings and stocks (though downside from here should be limited - stocks always go to extremes so maybe 10 - 15%), while tail risks (deflationary spiral/hyper-inflation or overheated recovery) are off the table, implying riskier credits will be okay and treasury bonds are not set to tank anytime soon due to the lack of economic traction. Oil, which is stuck in a trading range, also seems to concur. If economic growth were really about to plummet oil would be acting a lot worse. We will see if this explanantion plays out, for now it seems to best explain the interesting trends I see in the markets. Technical action in the stock market still leaves me cautious on equities, but I'm not in the deflationary spiral camp and I don't think Mr. Market is either.