Underlying Theme of the Market Remains Steadfastly Bullish

by: Thomas MacLeod

If one was to take today's newspapers, television, and financial websites/blogs at face value one could be forgiven for thinking that the end has arrived for Greece and perhaps the end is near for the eurozone. The media relaying popular opinion would also have us believe that global equity markets, commodities and high yielding currencies are about to fall into the abyss.

If there is one thing that we have learned over the past 20 odd years of investing it would be that forecasting is essentially a fruitless exercise. So if we are unable to determine what lies in the future what do we do? Well we know that markets move in broad based trends, that there are underlying themes driving the returns of stocks, commodities, currencies etc. We know that once in motion these trends tend to last for considerable lengths of time. So we attempt to identify the underlying theme or mood of the market and ride with it.

What theme is currently running through world financial markets? Well, believe it or not it remains yield seeking. There are a number of ways to identify this theme. Below we present two ways. The first chart is the spread between yields of emerging markets and US Treasuries. If the market is in a yield seeking condition it will seek out the relative high yields of emerging market debt and accordingly one will observe a tightening of the spread. This is currently what is happening. Glance your eye over the chart below. Is it exhibiting behavior out of the ordinary? Yes, you will observe that the spread did widen yesterday, but that is not enough to draw into question the overall trend

JP Morgan EMBI Sovereign Spread

Click to enlarge

We can also approach the whole yield seeking puzzle by the cost of insuring junk grade bonds from default vs. Investment grade bonds. The chart below is one we developed ourselves which in essence looks at the US junk grade CDS index / the US investment grade CDS Index (note the scale is going from negative to positive).

In essence, if the index is advancing it is saying that the crowd is willing to pay less of a premium to insure junk grade bonds from defaulting relative to investment grade bonds. I guess the big driver of the chart below is expectations of future cashflows. Higher cashflows suggest that there is less of a chance of default. The chart below continues to look bullish to us. Yes, momentum has waned over the last 8 months but then what do you expect given it came from the depths of despair some 18-12 months ago!

Proprietary Chart of Spread Between Junk and Investment Grade CDS

Click to enlarge

One should only judge a market by its actions not the words of the crowd (newspapers and magazines). At this stage the market remains positioned in a risk taking condition. How long will this condition last? One could speculate that given the market (world equities) has managed to withstand the barrage of negative news/panic from the PIIGs "fiasco", if it hasn't moved to a risk aversion yet it probably has someway to go. That is, don't be surprised to see continued strength in world equity markets over the coming months. We continue to see any weakness in world equity markets as a buying opportunity. Judge us by our actions, not words!

Disclosure: Author holds long positions in VTI, EFA