QE3 Is You and Me: Implications on the Summer Crash

Includes: IVV, SPY, TLT, XLP, XLU, XLV
by: Michael A. Gayed, CFA

On May 23rd of this year, I published an article titled "QE3 is You and Me: How Investors Can Replace the Fed" in which I argued that "the herd will replace the Fed in the bond market this time around." Much of my reasoning at the time had to do with 1) the still overwhelming bearishness that existed towards bonds, and 2) the fact that the bond/stock price ratio had been trending higher since mid-February. Further in the article, I put up a comment arguing that "if 10 year rates dip below 3% again it might cause a mini-panic in risk assets and accelerate a more formal QE-lite by the Fed."

So far, it appears my initial thinking was correct, though we have yet to see the Feds hand just yet. In many ways, the market has done what the Fed has not just yet. Despite QE2 ending, bond rates have continued to trend lower in a troubling way. Bond investors tend to be much more accurate about the future state of the economy than stock investors. What this means is that we should all be concerned with what the bond market is suggesting, especially given that 2 year yields are once again approaching record all-time lows in the midst of a "global recovery."

Is it over? Are we now seeing the low in rates, and a bottom in risk assets? To answer this, lets take a look below at the price ratio of the iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT) relative to the S&P 500 (NYSEARCA:IVV). A rising ratio means the numerator/TLT is outperforming (up more/down less) the denominator/IVV.

(Click to enlarge)

The main thing I want to emphasize here is that the ratio trend is still very much intact. Bonds appear to be likely to continue to outperform equities in the near term. However, it appears to want to do so even at such incredibly low rates. The bond market seems to be incredibly afraid of something that equity investors have yet to pay attention to. Whether the reasoning has to do with the Eurozone, China, or a global deflationary pulse, leadership appears to want to persist.

Given that the bond/stock ratio has lagged in terms of magnitude the outperformance of defensive sectors of the market such as Consumer Staples (NYSEARCA:XLP), Utilities (NYSEARCA:XLU), and Healthcare (NYSEARCA:XLV) over recent months, the only real way for the bond/stock ratio to adjust higher is through the denominator (stocks) to decline, and potentially decline in a crash-like way in the summer as I have been arguing for most of the month.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.