Dilemmas: Stocks Or Bonds, Long Or Short?

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 |  Includes: AGG, ITB, QQQ, SH, SPY, TLT, VTI, XLE, XLF
by: Chris Ciovacco

All Investing Involves Opportunity Costs

According to Wikipedia, the opportunity cost of a choice is "the value of the best alternative forgone, in a situation in which a choice needs to be made between several mutually exclusive alternatives given limited resources." In the investing world, we all have limited resources. We all need to make choices in terms of allocating those limited resources; would we rather be long or short stocks? Would we rather be in stocks or in bonds?

Central Banks Create Dilemma

In a process known as quantitative easing, central banks around the globe are buying government bonds in an effort to keep interest rates low and, more importantly, drive asset prices higher. Low rates and a global financial system flush with freshly printed money make stocks more attractive.

The markets were spooked last week when Ben Bernanke hinted the Fed's pace of bond buying may slow in the coming months. In theory, less printed money being injected into the financial system will makes stocks less attractive. On the one hand, the logical response by investors would be to migrate back to bonds. On the other hand, if the Fed is planning to buy fewer bonds that means the greatest source of bond demand is on the verge of being cut. That can't be good for bond prices … right?

Would I rather be in stocks or bonds?

The aggregate supply and demand balance of all investors around the globe sets asset prices. A good way to get a read on that aggregate supply and demand balance is to look at charts. This week's video uses charts to help answer the questions:

  • Would I rather be in stocks or in bonds? - see 16:24 mark of video
  • Would I rather be long or short? - 14:38 mark of video

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.

Video

Our "aggregate supply and demand" approach can be used to monitor longer-term trends in the demand for stocks relative to the demand for bonds. It is always helpful to compare investment alternatives head-to-head before making opportunity cost decisions. The chart below shows the performance of the S&P 500 (NYSEARCA:SPY) relative to a diversified portfolio of bonds (NYSEARCA:AGG). The weekly trend in the chart below, as of May 24, favors stocks over bonds.

Fed Tries To Temper "Tapering" Fears

After a double dose of Congressional Q&A with Ben Bernanke and the release of Fed minutes, the S&P 500 dropped 50 points from Wednesday's high to Friday's low. Investors feared discussions within the Fed to taper bond purchases in the coming months.

The bulk of the tapering-induced drop came Wednesday afternoon. The Fed was quick to come out in an effort to calm the markets. Bloomberg reported on Thursday, May 23:

Federal Reserve Bank of San Francisco President John Williams, emphasizing the need for policy flexibility, said any move to reduce the pace of the central bank's bond buying could be followed by an increase should the economy weaken again. "Even if we do adjust downward our purchases, it doesn't mean we're now in some autopilot of moving in the same direction," Williams, 50, said in an interview yesterday in San Francisco. "You could even imagine a scenario where we adjust it downward based on good data and then adjust it back" if the economy weakened.

Would I rather be long or short?

The weekly chart below shows the performance of longs relative to shorts (NYSEARCA:SH). When the ratio rises, we would "rather be long" and when the ratio falls, the short side of the market is outperforming the long side. The weekly chart helps us stay with the dominant trend by filtering out some distracting volatility present on a daily chart. The red and blue lines are moving averages which filter out some of the week-to-week volatility. The chart below is in the most bullish state (favoring being long stocks): (1) price is above the red and blue moving averages, and (2) the slopes of the red and blue moving averages are positive.

The Most Important Thing - Central Banks

With some additional help from central banks, the financial markets resumed their weekly bullish trends early in Tuesday's session. After the holiday weekend, the stock market bears were greeted with big gains in the futures. The global rally was helped in part by more "loose" comments from those in charge of the printing presses. From Reuters:

The Nikkei .N225 steadied on Tuesday, ending 1.2 percent higher after long-serving board member Ryuzo Miyao said the Bank of Japan would fine-tune market operations to ensure its unprecedented easing campaign is not derailed. ECB Executive Board member Peter Praet said the bank could still cut interest rates further to stimulate the economy if needed. His comment echoed that of ECB Executive Board member Joerg Asmussen on Monday who said the loose policy would stay as long as necessary.

Investment Implications

As we noted on May 14, as long as central banks remain accommodative and the weekly trends positive, we will continue to favor the long side of the market over the short side. We will also favor stocks (NYSEARCA:VTI) over bonds (NYSEARCA:TLT). Our focus continues to be on more economically sensitive areas, such as financials (NYSEARCA:XLF), energy (NYSEARCA:XLE), home builders (NYSEARCA:ITB), and technology (NASDAQ:QQQ).

In an environment where central banks are playing arguably their most important and intrusive role ever, the speculative bent of the markets requires maximum flexibility and open-mindedness. As evidenced by the sharp plunge last Wednesday afternoon, conditions can change rapidly when central banks suggest even a relatively minor change in policy.

Disclosure: I am long QQQ, SPY, XLE, ITB, XLF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.