Bonds Ask 'How Do You Like Me Now?'

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 |  Includes: BIL, DLBL, DLBS, DSTJ, DSXJ, DTUL, DTUS, DTYL, DTYS, EDV, FIVZ, IEF, IEI, ILTB, ITE, IVV, LBND, PST, SBND, SHV, SHY, TBF, TBT, TENZ, TLH, TLO, TLT, TMF, TMV, TUZ, TYD, TYO, UBT, UST, VGIT, VGLT, VGSH
by: Michael A. Gayed, CFA

Just a month ago I was remarking to my investment team how amazingly one-sided the rhetoric became over rising rates/declining bonds. Following the announcement of QE2, rates rose strongly off of the lows hit last year across the yield curve. Only last month, however, did I begin noticing the extent to which investors and advisors believed in the rising rate/hate bonds/love stocks story.

IndexUniverse.com which tracks fund flows had on its homepage a headline a few weeks ago something along the lines of "Short Bond ETFs are Hot," citing advisors who were buying ETFs which short bonds. In a recent edition of Investment News, I noticed multiple articles detailing how advisors are bearish on bonds and were aggressively underweighting them in client portfolios.

In many ways, the contrarian trade has become to favor bonds over stocks. On February 22, I published a piece here on Seeking Alpha titled "Treasuries on Verge of a Comeback?" in which I stated "... while everyone has been trashing Treasuries, there is a possibility that they begin to rally in a strong way in the comnig weeks relative to equities as the fear trade gets priced back into stocks." I also noted on March 1 (before the tragic events in Japan occurred) that "the Correction Transition Begins."

The reasoning for such calls relates to 1) the extent of out/underperformance, and 2) magnitude. Equities substantially outperformed bonds since September. Furthermore, defensive sector ratios relative to the stock market clearly showed a bottoming out process, indicating that long-only managers were likely starting to overweight lower beta stocks in anticipation of a correction. And yes – bonds began outperforming stocks before the earthquake/Tsunami hit Japan. Take a look at the price ratio below of the iShares Barclays 7-10 Year Treasury Bond Fund (NYSEARCA:IEF) to the S&P 500 (NYSEARCA:IVV). As a reminder, a rising price ratio means the numerator/IEF is outperforming (up more/down less) the denominator/IVV.

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(Click to enlarge)

Notice that the ratio bottomed out in February, and has been rising ever since. Strength in bonds relative to equities may very well continue in the near term, and that should not be a surprise. Given weak housing (which appears to be double dipping), China trying to slow down its economy, and concerns over Japan and the Middle East, one must ask the question of whether bonds in our current environment should remain such a disliked asset class.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Pension Partners, LLC, and/or its clients may hold positions in securities mentioned in this article at time of writing.