3 Things Worth Thinking About (Vol.18)

Stock/Bond Ratio Not Confirming Rally

Following the October swoon, stocks have vaulted to all-time highs. As I discussed previously in "Sentiment Is Off The Charts Bullish," there have only been few occasions where investors have felt so "giddy" about the financial markets. Such periods of exuberance have never ended well for investors as they were deluded by near-term"greed" which blinded them to the building risks.

One of the things that I pay attention to is the ratio of the S&P 500 compared to longer duration bonds. The theory is that when investors are willing to take on more risk, money flows out of "safe haven" like bonds to equities as portfolio allocations become more aggressively tilted. The opposite occurs as investors began to reduce "risk exposure" in portfolios and focus more on "safety."

As you can see in the chart below, there is a very high level of correlation between the rise and fall of the stock/bond ratio and the S&P 500. Well, that is until just lately.

SP500-Stock-Bond-Ratio-112014

Notice that currently, the ratio has deviated substantially from its normal correlation with the S&P 500 index. Importantly, this deviation began precisely when the Federal Reserve began extracting their liquidity support from the financial markets at the beginning of this year. With money rotating from "risk to safety" it is likely a clear warning that risks of a more substantial correction are building.

Given the economic slowdown globally, as discussed yesterday, rising deflationary pressures and elevated valuations it is highly likely that the majority of market gains have already been achieved. Furthermore, with the Federal Reserve now signaling that they are focused on raising interest rates, the tightening of monetary policy in an extremely weak economic environment will be a stronger headwind than currently anticipated. 

With everybody seemingly in the "bullish camp," and a good degree of history forgotten, Bob Farrell's rule #9 comes to mind:

"When everyone agrees; something else is bound to happen."

While the markets are indeed hitting new highs, this is an event that has only occurred during very short periods of our long market history. Of course, this only makes sense that when considering that the market spends the majority of its time making up previous losses. As my father often told me:

"Breaking even is not an investment strategy."

Market Finally Breaks Even

Speaking of "breaking even," investors can rejoice that after 14 years and 3 months they have once again broken even on an inflation adjusted basis. As shown in the chart below, it took 24 years previously for the S&P 500 to round trip back to positive territory.

SP500-TimeBetweenNewHighs-112014

Anthony Mirhaydari made some interesting observations in the Fiscal Times:

"On a number of measures, it's looking long in the tooth and vulnerable. Here's why.

Longevity: This bull market is currently the fourth longest out of 23 in terms of duration and is the sixth best in terms of total percentage gain. That puts this well ahead of the average for the Dow Jones Industrial Average going back to 1897, when Grover Cleveland was president and Mark Twain famously quipped that the 'report of my death was an exaggeration.'

The three other bull markets that outlived the current one started in 1949, 1990, and 1921. None lasted longer than eight years. So, at the very least, this suggests the bull market will be unable to live past 2017 putting the date of the final top, conservatively, sometime in 2016.

Evidence is building that market conditions suggest caution is warranted.

Short-term: Since the October 15th low, the S&P 500 has yet to close below its five-day moving average — a run of consistency that hasn't been seen since the 1990s.

The current range on the S&P 500 is the tightest in history. Over the last six sessions the S&P 500 hasn't moved more than 0.077 percent on a closing basis. The next tightest range was in 1965 at 0.080 percent.

Moreover, breath is tightening as U.S. large-caps look invincible. The Russell 2000 small-cap index dropped 0.8 percent on Monday for its third loss in a row — its worst streak since the middle of October. The iShares High-Yield Corporate Bond Fund (HYG) is down four days in a row, pushing below its 200-day moving average as junk bonds come under pressure. And the CBOE Volatility Index, Wall Street's "fear gauge," has popped back over its 200-day moving average and is up 11.9 percent from its intraday lows last Monday.

Medium-term: Valuation metrics are more than fully valued. The cyclically adjusted S&P 500 price-to-earnings ratio is at levels that have only been exceeded in the run up to the 1929, 2000, and 2007 market bubbles. Investor sentiment is extended, with mutual fund cash reserves at record lows." (Click here for charts)

Good food for thought.

What Are Commodities Saying About The Economy

Staying with the "market versus the economy" theme, the continuing decline in commodity prices is certainly worth noting. As shown in the chart below, the general trend of commodity prices has a fairly close relationship to overall economic growth.

Commodities-Economy-112014

This relationship is not surprising given that when an economy is growing, the demand for commodities to consume, manufacture or produce goods and services rises which cause prices to rise. However, the current decline in commodity prices suggests that the globally weak economic environment is a rising deflationary force.

While economic growth in the U.S. rebounded sharply for the 2.1% decline in the first quarter, the question of sustainability remains in question. Internationally, the weakness of global growth, a rising U.S. dollar and weak foreign demand will likely weigh on exports and corporate profits.

Domestically, the early bout of extremely cold winter weather, stagnant wage growth and the impact of higher healthcare costs and taxes from the full onset of the Affordable Care Act will provide additional headwinds.

Commodities are likely telling a story about the real economy. Jeffrey Snider at Alhambra Investment Partners summed up this idea well:

"This correlation can be extended to other commodity prices as well, which again precludes the predominance of 'supply' as the driving force in prices. Credit markets and oil prices are in tandem warning about the next phase of 'global growth' as it exists within the modern occurrence of the elongated business cycle.  If the history of that since 1985 is indicative of what to expect, the elongated peak may be finally coming to an end. That would fit with intuitive perceptions where central bank actions after the 2012 slowdown are coming up far short of intents, and thus that deficient baseline is once again being revealed as well beyond monetary 'aid.'”

 

Disclosure: The information contained in this article should not be construed as financial or investment advice on any subject matter. Streettalk Advisors, LLC expressly disclaims all liability in ...

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