Intermarket Analysis Picture has us Worried

Monday, October 27, 2014

It is often said you can glean more from a market’s rebound than its initial fall.

The intermarket analysis has us worried:

The S&P500 made a ‘panicky’ low of 1820 on the 15th of October and has rebounded smartly to 1964 an increase of 8% in 7 trading days.

If this were a movie script we could discern no surprising twist or turns, yet. The market needed at 10% correction everyone and his dog asked for one, we got it and the market is now whistling past the graveyard on its way to new highs (?)

Make no mistake, a lot of technical damage occurred with numerous stocks falling more than 10% and slower to recover than the averages, but it is the general lack of surprises that has us worried. The market is notorious for not following a convenient script.

In particular, the Treasury market has not behaved as we would expect. Already at over-bought levels, Treasuries moved higher (in a flight to safety) as the equity market sold down – but wait – there was nary a blip lower in Treasuries as the equity market rocketed higher over the last 7 trading days. Logically Treasuries should have pulled back as equities rebounded – after all it is growth or deflation – it cannot be both.

In fact there are a few reasons we think this Treasury rally may have some legs (which is not overall positive for equities):

Firstly: Sentiment remains either incredulous or disbelieving of higher Treasury prices (lower rates). The general consensus is that this rally in Treasuries, since the beginning of the year, was an unexpected aberration. The commitment of traders (net futures position in 10 year treasury by speculators) still shows them to be overwhelming bearish on US Treasuries (short). What you normally find at a market top is a large net long futures position by speculators. The current situation is the opposite and can provide further fuel for the rally (look at Jan to March 2013 for what we would expect, long speculators [blue bars] and lower rates [red line]).

Figure 1 – 10Y US Treasury Commitment of Traders

10Y US Treasury Commitment of Traders.png” alt="10Y US Treasury Commitment of Traders

Second: Relative Valuation among comparable bonds. Compared to Euro-denominated 10-year bonds Germany, France and Spain are yielding 0.9%, 1.3% and 2.2%, respectively, and Yen-denominated 10-year bonds yielding 0.5%. The US 10-Year note looks rich at 2.27%. This should encourage some continued positive flow into US-Treasuries.

Third: Relative Valuation of Stocks vs Bonds. A traditional measure is to compare the earnings yield of the S&P500 (5.3%) to Investment Grade AAA bonds (3.8%) – and selecting the higher yielding as the preferred asset class (stocks in this case).

HOWEVER, a long term chart of the S&P500 versus the 30Y US-Treasury Bond shows the market at an extreme valuation in favor of stocks versus bonds. In fact the last 2 times this extreme was reached was in 2000 and 2007 – both preceded large bear markets. It is ironic that we have been hearing about the coming rotation from bonds to stocks – what this chart shows is that said rotation has already occurred.

Figure 2 – S&P500 v 30Y US-Treasury Bonds (rising line = stocks outperforming)

intermarket analysis of S&P500 v 30Y US-Treasury Bonds.gif” alt="intermarket analysis of S&P500 v 30Y US-Treasury Bonds (rising line = stocks outperforming)

This ratio moved above 14 at the end of last year and broke below its 50-week MA over the past two weeks – a warning flag.

To reiterate we have no way of knowing if this correction was part of a larger bull move or the beginning of a bear market in equities. There is however ample reasons for treasuries to continue rallying which on-balance would signify slower growth and is negative for equities … at this point we are watching to see whether the market retests its recent lows [perhaps on further Ebola fears] and whether those would hold. We are also adding to our fixed income duration exposure in central portfolios.

Warm Regards,
Greg

Greg Silberman CFA®, CAIA, CA(SA)

Chief Investment Officer

Advisory Services offered through Atlanta Capital Group.

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