The Red Flag the Stock Market's Ignoring

These days, the stock market doesn't know whether to turn up, fall down, or crawl sideways. One thing's sure, however -- even with the fall from April's peak and the subsequent volatility, U.S. stocks still appear to be pricing in a sustained economic recovery.

But that's unlikely to be what we get -- at least according the $7.9 trillion U.S. Treasury market.

Two markets diverged ....
Whether we're talking stock, bond, or commodity markets, let's first clarify that I don't recommend relying on price action as a measure of future growth in the real economy. Arguably more reliable indicators include GDP or trends in mass layoffs. Markets, after all, are infamously irrational.

That said, there is a time to pay keen attention to market action, and that's when trading in U.S. Treasuries suggests an economic outcome far different from what the stock market expects.

The elephant in the room
Granted, the Treasury market doesn't quite stack up to the roughly $13.4 trillion market cap of U.S. stocks. Yet as a barometer of investor attitude, it does an equally fine job.

With repayment risk as close to zero as realistically possible, the going yield on Treasury bills, notes, and bonds isolates (and reflects) interest-rate and inflation expectations, which in turn broadcasts the market's estimation of future economic health. In general, abnormally low yields suggest a fragile, plodding economy, while unusually high yields may indicate fear that economic expansion or other events will give way to ruinously high inflation.

Enough from me, though. Let's go straight to David Rosenberg, a well-known market strategist who boasts a flair for statistical analysis.

At the end of April, Rosenberg wrote, "We still have the 10-year T-note yield hanging around 3.7% whereas if we were truly in a wonderful reflationary cycle, it should be north of 4.5% right now." In the month since, the 10-year yield has fallen to a current 3.3% (yields move inversely with prices). Importantly, that change may reflect more than market jitters and a concomitant flight to safety.

Bond investors, one might argue, are taking a more skeptical angle on recent economic data points. For instance, Rosenberg notes that the "core control" segment of April retail sales, which excludes autos, gasoline, and building materials, posted the largest month-over-month drop since March 2009. Meanwhile, consumer confidence, although improved, remains smack in recession territory. What's more, consumers' plans to purchase big-ticket items, such as a major appliance or home, trended down in May. That development doesn't bode well for the likes of Sears Holdings (NYSE: SHLD  ) , Home Depot (NYSE: HD  ) , or Best Buy (NYSE: BBY  ) .

Want more evidence of a shaky economy?

Excluding government backstops, Rosenberg observes that real personal income has "barely budged" and remains well below its peak 16 months ago. Furthermore, citing Wal-Mart's (NYSE: WMT  ) price cuts on 10,000 items and the recent emergence of $2 combo meals at Yum! Brands' (NYSE: YUM  ) Taco Bell chain, Rosenberg quips, "That is deflation, not disinflation or inflation or any other 'flation." Said differently, without pricing power, how are companies going to produce the top-line growth that investors will eventually demand?

Something of a golden lining
While evidence of a feeble economy is nothing to celebrate, it looks as though near-term fears of rising Treasury yields -- which, if realized, would likely push up private borrowing costs and potentially cause a double-dip recession -- are overblown.

The now-familiar bond-bear stance argues that a burgeoning supply of Treasuries will overwhelm the market, crushing prices and driving up yields. Rosenberg recognizes the likelihood of such an outcome given an expanding economy, but he counters with the following:

There is no comparison between fiscal deficits and inflation when it comes to bond yield analysis ... With credit contracting, rents deflating, the broad money supply measures now declining and unit labour costs dropping at a record rate, it hardly seems plausible that inflation is a risk at any time on the near- or intermediate-term forecasting horizon.

Rosenberg offers numerous examples to support his claim, including the bond rally of 2002, as the U.S. deficit exploded and deflationary risks simultaneously moved to the fore; the bond bull of the Reagan years, when Treasury supply ballooned; and finally, the Japan of the past decade.

"Yes, Virginia," affirms Rosenberg, "deficits and deflation can co-exist for extended periods of time."

Even so, Rosenberg is a gold bull. Notably, he sees the glittering metal as a hedge against the financial instability engendered by both deflation and its late-arriving cousin, inflation. His gold-price forecast ranges from $3,100 per ounce to $5,700 per ounce, depending on the terms in which one measures former highs.

For investors who share this affinity for bullion, SPDR Gold Shares (NYSE: GLD  ) , or, even better, Central Fund of Canada (AMEX: CEF  ) , are the obvious plays. If, on the other hand, you can't work yourself up to that gold-bug itch but nonetheless agree with the bond market's implied economic outlook, consider instead these must-have stocks for the next correction.

Best Buy, Home Depot, and Wal-Mart Stores are Motley Fool Inside Value selections. Best Buy is a Motley Fool Stock Advisor pick. Motley Fool Options has recommended a bull call spread position on Best Buy. Motley Fool Options has recommended a bull call spread position on Yum! Brands. The Fool owns shares of Best Buy. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Mike Pienciak holds no financial interest in any company mentioned in this article. The Fool has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (16)

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  • Report this Comment On June 03, 2010, at 6:19 PM, YetBiggerD wrote:

    It seems to me this article misses the obvious point - if you believe that a 3% bond yield and a equities market with a recovery priced in are incompatible, you don't need to decide which is right. You simply need to trade the inconsistency - short treasuries/futures and short index futures. One will have to move to reflect the other - either there will be a continued recovery (in which case stocks will be priced approximately correctly and bond prices will fall) or there won't be (in which case bonds will be priced right and equities will fall).

    Of course the danger in such an approach, aside from putting on a very complicated trade by the standards of the average investor, is your analysis might be wrong and if if it's right the market may continue on irrationally longer than you can maintain your position.

  • Report this Comment On June 03, 2010, at 6:53 PM, YetBiggerD wrote:

    Another thought: let's assume for simplicity's sake that the equity guys are right, and the bond guys are wrong. In order to have economic growth, T bond rates will have to rise to about what they were last time we had growth - 4-5% in the 2005-6 time frame. What would bond prices look like if that happened? Right now the 10 year T-bond future is trading at about 120. With a 4-5% yield that would drop somewhere in the 105 to 112 range. So if you shorted bonds you'd be looking at an 8-15 point profit on a 120 point investment over maybe 2-3 years as the irrationality sorted itself out. If the bond guys were right and the equity guys are wrong, you'd be looking at a similarly sized profit shorting equities. Those returns aren't exactly breathtaking. Sure, you could leverage the trade to the gills, but then you're even more likely to be right but not be around to profit from it.

    This idea could easily be totally correct and yet untradable in practice.

  • Report this Comment On June 04, 2010, at 9:45 AM, FutureMonkey wrote:

    What the bond-equities pricing riddle tells me is that there is a whole lot of money looking for a home but nobody is sure what to do with it. Some smart corporation looking to expand operations, take out a competitor, or retool could borrow at these very generous rates with minimal cost bond debt.

    It also tells me that there is a broad lack of patience among investors that are accustom to fast money, resulting in much greater volatility generated by influence on the market quite beyond value of the businesses in the market.

    Imagine you are big enough to actually influence market action. Market timing actually makes sense if you control the market. If equities are still overpriced, no need to wait around for enterprise value to rise over time during a long secular bear; just gotta push up price, higher, sheer the sheep, repeat. Too bad that doesn't work with us regular joes. Somebody is doing it and making a killing, while the rest of us just keep paddling.

  • Report this Comment On June 04, 2010, at 12:19 PM, EvilPhD wrote:

    Suppose positive profit sheets don't mean crap for companies anymore. WTF is wrong with you "Harvard Educated" big fund investors? Got 11,000 anxiety?

    Seems like big managers are forcing the market to stay at 10K and by that means your own shorts are your downfalls.

    I know my 100 shares of X company is just a drop in the bucket but damn wall street are you that dumb or is it that you are too corrupt that you are just stealing money from the non-insiders and playing puppet with the market?

    I mean damn, this market is like some Tyler Perry drama box. Oh no, most of the jobs are temps!

    IT"S MORE MONEY IN CONSUMER POCKETS IDIOTS!

    Really!? Really man. I don't know about you fools, but that means more people buying crap and a higher consumer confidence - even if it is short term it stems losses and keeps up that ever unimportant balance sheet. It also give more people experience in a different skill set.

    I swear these "my daddy can afford ivy college Major Bull Assessors" that control these funds are corrupted at the school level.

    Keep shooting yourself in the foot and cannibalizing the market with your short calls, then when you can't walk and wonder what happened to your foot you have only your corrupt greed to blame.

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