BONDS SAY DEFLATION, STOCKS SAY REFLATION. WHO IS RIGHT?
Stocks have surged 11% since June 10th. At the same time, the 10 year treasury yield has declined almost 70 basis points to close at 3.18% yesterday. What is curious here is that the stock market is telling a very different story from the bond market. Bond investors (who tend to have a longer time horizon) are forecasting a long battle with deflation. Equity investors (who tend not to think much farther than one quarter into the future), on the other hand, are putting their money on the line in the hopes that the reflation trade is alive and well.
Unfortunately for equity investors, they have a poor record of forecasting the future when compared to bond investors. There have been 4 famous cases of such bond and stock divergences in the last 20 years. The most famous is the summer of 1987. We all know what occurred then. The other three cases were fall ’94, summer ’98 and winter 2000. All three preceded declines in the market. Of all 4 instances, three of them preceded 15% declines in the S&P 500.
The real crux of the issue here is not terribly complex. In order for corporations to tack on to the $80 in operating earnings that the equity market is currently pricing in for 2010, they will need pricing power. The cost cutting and resulting margin expansion we are seeing is great in the near-term, but we’re unlikely to see pricing power and hence real revenue expansion without at least some inflation. The bond market, however, is pricing in little to no inflation. The bond market’s message is clear – we are in a deflationary world. That doesn’t bode well for the prospect of corporate earnings and that likely means stocks are getting a bit frothy here. Investors would be wise to take a step back and reconsider the risk/reward of owning equities once the euphoria surrounding Q3 earnings wears off….
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You’re going to see this market begin to go down soon. Maybe not crash and burn, but DOW around 8700-9000.
What about Q4 ’07? Bonds definitely foreshadowed correctly then as well.
Just read the title. Bonds say inflation too. Goldilocks is back and we now know she always was an artificial, silicon implanted manufactured wonder.
Bonds say no CPI but plenty asset inflation through monetary excesses. Same as before. And that’s the main reason gold is rising.
Regards
W
The 4 examples were never followed by deflation (CPI) .. they were followed by temporary asset deflation due to allocation away from equities. Equities are up along with T’s because corporate debt risk (perceived) has come down; they will decouple when that sentiment changes … it’s asset allocation not delfation (yet).
If banks can borrow at 0.25% and make 2% on 5 year and 3.2% on 10yr Treasuries that is a (risky) but huge return. The Fed doesn’t need to buy Treasuries directly. Banks can short the dollar and buy just about any asset. The question is how long will the carry trade last and how quickly it might unwind if the dollar reverses and the dollar shorts start covering. The Yen moved from 169 to 118 YEN/EUR (+40%) in a few short months when the carry trade unwound there last year. If there is a reversal, there could be a powerful move up in the dollar and down in asset prices on dollar short covering. The opposite of what was seen off the March lows.
Powerful rally 107.07 at this minute and USD another new low
Earnings are going to be good. I fully expect stocks to get far overbought in the coming weeks. That will be something to sell into….
The two asset classes may be telling telling the same tale. Stocks has historically been a leading indicator. They are nourished by earnings. Currently, productivty gains of companies are indicating in the future that earnings will be better. Bonds are driven by current rates. They suggest that the Fed will keep rates low. Stocks will benefit from low rates as it creates a good market for exports. Thus, a slow growth economy with chronically high unemployment – due to a threatening government – allows stocks to thrive on productivity and bonds to thrive on low rates. When top line growth begins, stocks will thrive. This is when the Fed may begin to raise rates. This action will slow exportation due to a stronger dollar and push bond prices down at the same time. The difference will be that stocks will recover. Bonds will not, at least, for a cycle.
2010 – Dow 5000
Stocks have surged 11% since June 10th. At the same time, the 10 year treasury yield has declined almost 70 basis points to close at 3.18% yesterday.
Isn’t Stocks also pricing in deflation? – You are discounting (cash flows) at a lower rate (decline of 70 basis points in RFR) plus the credit risk premium is also declining.