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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.” 

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