Will Risk Taking Reward Investors Now?

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 |  Includes: DIA, KMB, QQQ, SPY, TLT, UDN, UUP, VXX, VXZ
by: Surly Trader

It seems that the market is in a precarious position. After a few months of very weak trading, we have experienced a fairly significant 10% bounce off of the lows and now the S&P 500 sits within a few points of June highs. The positive price action stems from decent corporate earnings results and outlooks, short covering, a bounce in the Euro, and the release of European bank stress tests (for whatever they are worth).

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Dead Cat Bounce?

Some other positive data items for the return of the “risk trade” are a falling dollar, rising AUD, mostly rising commodities and a very weak VIX.

On the flip side of this risk trade is the fact that interest rates remain stubbornly low:

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The Ten Year will not follow - which do you believe?

In addition to low treasury rates, there are a few leading indicators that are a bit troublesome. Most have been touting the absolute proof of a double dip recession based upon the Economic Cycle Research Institute’s Leading Indicator’s negative growth rate of -10.5%:

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The ECRI has become the current hot predictor of catastrophe

As with all signals, nothing is perfect. The ECRI has gone negative before without recessions, but the research institute is fast to explain away all false readings. I suggest you pick up their book to figure out how they suggest that you use their tools. I am sure that if we did experience a double dip, then the institute would be quick to claim that they predicted it.

What had me a bit concerned Tuesday was a rather weak reading from the Chicago Fed National Activity Index. The index has a lot of noise in its data, but the sharp downturn does not leave you with a lot of comfort:

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CFNAI takes a quick downturn

So what does it all mean? As I have said in the past, either equity markets and the underlying corporations are too euphoric or the bond market has it all wrong. Today, new issue Kimberly-Clark (NYSE:KMB) 10 year corporate bonds are priced at about a 3.65% yield while their stock pays a 4.12% dividend yield. Something is not quite right with that picture. This dilemma lies at the heart of the inflationist/deflationist battle. Either the equity is attractive, the bonds are very rich, or maybe there is a sweet spot in-between.

If we can believe in a stable economy going forward, without revisiting a strong downturn, then the stock is most likely cheap and the underlying 10 year interest rate is too low. If the treasury rates and the economic indicators point to a double dip, then a full force of deflation is on us and look out for Quantitative Easing 2.0. Either you can pick your side or watch from the sidelines.

Disclosure: Short VXZ