Chart of the Day: Follow the Money

By Lance Roberts, CEO, StreetTalk Advisors

I posted the following chart in this past weekend’s missive “The ‘Maybe’ Syndrome” where in I stated:  “There is one other thing that is bothering me about the recent rally in July – smart money isn’t following it.”

The bond market is substantially larger than the stock market, and while stock market participants are all about taking risk, players in the bond market are about analyzing and managing credit risk.  Therefore, historically, the bond market has been a much better gauge in regards to risk management than the stock market.  For example, in the summer of 2011, when the markets plunged on fears of a domestic “debt default” - the yield on the 10-year treasury sank below 2% as money flowed INTO treasuries.  The bond market was clearly telling investors that chose to listen that no default was imminent.

Moreover, when the stock market has been rising due to strength in fundamental underpinnings money rotated from from the bond market (driving interest rates up) into the stock market (driving prices up) and vice versa.  You can see that relationship remaining intact even through QE1 and QE2 – until now.  Over the past two months, as stock prices have risen, the bond market has not confirmed that additional “risk taking” is warranted.

It is entirely possible that the bond market is just late to the party.  If the markets can continue its rally we might very well see capitulation as money managers sell bonds to rotate back into stocks.  However, with fundamentals weak and economics deteriorating, absent further stimulative programs it is difficult to see what could continue to drive markets higher in the intermediate term.   Furthermore, that capitulation, should it occur, tends to happen nearer market tops than bottoms.

As we stated this past weekend:  “August and September tend to be tricky months.  They both have seen their share of rallies and brutal defeats.  It is an election year which does provide some historical support to the markets, however, I would not bet heavily on that historical tendency.”  This is definitely not a normal market environment and stocks are pushing higher based more on assumptions, and hope, rather than facts.   This leaves the market very susceptible to potential disappointment.

While the markets push forward on “hope” for more intervention by Central Banks – the bond market is signaling that it is not so sure help is coming any time soon.  The current divergence between stock prices and bond yields is at it widest level this century.  Either yields will rise sharply as money rotates into stocks pushing asset prices markedly higher or stock prices will fall to close the gap with yields.  What is for sure is that the current divergence is unlikely to be the “new normal.” 

Lance Roberts

Lance Roberts

Lance Roberts is the CEO of STA Wealth Managment. The mission of STA Wealth Managment is simple - lead our clients to financial success by actively managing their assets while limiting risk to capture returns. Through the utilization of economic and technical analysis, historical research, and risk controls, we build portfolios which will create long-term investment results.

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  • Andrew P

    That graph is fine and dandy, but how much historical precedent do we have for stock market performance in an environment of zero or negative treasury yields? Maybe the considerations of normal environments don’t apply during great depressions that are contained by massive and permanent central bank intervention. I think that Japan provides the most recent historical example, and that would argue for a market that slowly grinds lower with occasional big rallies over decades, while interest rates remain at zero.

  • Boston Larry

    Lance, thanks for your thoughts. The “dumb” money is doing well today, and have been doing well in this bull rally since early June. Investors seem to be excited about the prospects for ECB bond buying and coming QE3 from our Fed. If bond-buying by CB’s is driving this, then why are long US Treasuries selling off so sharply? How many would agree with my guess that the market is buying on the rumor of combined CB intervention, but will sell on the news???

  • jaymaster

    Maybe I’m interpreting this wrong, but it seems to me the major assumption underlying this analysis is flawed from an MR perspective.

    It seems Brad is saying that he believes interest rates rise when bond holders start selling their bonds and move those assets into stocks. And he is using yield as a proxy for volume of money moving into (or out of) the bond market.

    But from the MR perspective, that is dubious at best. The yield/rates are controlled entirely by the Fed/Treasury. And the Fed has stated consistently for some time that they intend to keep interest rates low.

  • BigHedge

    This may be too simple a way to look at it, but if the Fed is buying bonds pushing yields lower, which forces people into stocks. Then this chart tells that story. I dont think it is sustainable but I guess the Fed can do QE forever. What do I know??

  • 0mega

    Yes, you are interpreting the article and how bond auctions work, wrong. When people buy bonds, there is a set return on that bond. People bid on the bond. The percent yield the bond issues is a function of what the purchase price is, which changes depending on the demand for that particular bond, in that particular auction it was bought at. No one person or organizations controls the yield – it is what the market at that moment has determined it to be. The fed/treasury is not involved in that kind of rate setting. When the fed buys bonds, it is just another bidder with a deep pockets, which forces the price of the bond up, which in turn means the yield on that bond has gone down. The fed rate you’re referring to is different. I could explain more but it will take a while.

    Regarding Lance’s article, I think there are multiple reasons the bond market has decoupled from the equities market’s typical inverse correlation. To that point, the correlation hasn’t always been inverse. It’s just that in recent history that has been true. I think the other reason is the big players who have to keep safe money safe, have much more money than in recent history, and treasuries are the ‘cleanest shirt in a dirty basket’. Lending money has never been cheaper and they are more concerned with preserving capital than appreciation.

  • Brett A

    Flight to debt quality from foreign investors + recent equity investor confidence = the above decoupling. But who, exactly, is buying equities? Seems every man on the street is running scared, per the fund flows analysis, and still shifting $ from stocks to bonds (at negative real return)… Noobish.