On August 8, 2011, I posted this StockTalk:
Panic if both Treasuries and Markets sell, and sell hard. Not the case right now, would seem a buying opportunity.
The correlation between Treasuries and the broad market has been pretty well documented. When people sell stocks, much of the money is often reallocated into Treasuries, sending their rates lower. This is commonly referred to as the "risk-off trade". I decided to take a closer look at this concept, and how well it is holding up in the recent sell-off to determine if I needed to revise my stance.
First, I calculated the beta of the SPY with respect to the Inverse of the iShares 20 Year Treasury Trust ETF (TLT). To do this I looked at YTD daily returns of the SPY, and YTD inverse daily returns of the the TLT. To get the best beta number possible, I decided to used a weighted average of betas over varying time intervals. Each beta calculation was based off daily adjusted returns for SPY as the Y variable, and TLT as the X variable. The number shown is the average of trailing 1 month beta, trailing 3 month beta, trailing 6 month beta, trailing 1 year beta, and trailing 2 year beta.
Below is a chart of the time series over the past year (click to enlarge images):
As you can see, based on this calculation, the beta for SPY with respect to the Inverse of TLT is currently ~.68. Meaning, if TLT gained 1% you would expect SPY to lose .68. Even though the beta fluctuates, it remains positive throughout the year. This comes as no surprise, and confirms the common theory - when people sell stocks, they buy bonds - hence, "risk-off".
Next, I looked at the residuals of the SPY daily performance against the expectation based on the beta with respect to TLT. Below is chart of these residuals.
Since the debt ceiling deal on August 1st we have seen the greatest deviations from this regression, which reflects the uncertainty in the market. If we zoom in on the past 2 weeks, we can see that despite some hugely positive days, the cumulative relative performance has been quite negative. It begs the question, if people aren't buying equities or Treasuries where is this money going? Gold would seem like a logical answer, as it is the Treasury bond's other "riskless" counterpart. Shown below, gold virtually has been the inverse of this performance ratio over the past 2 weeks. My personal beliefs aside (why not other commodities? why not emerging market currencies?), the interrelationship between these three asset classes is hard to ignore.
Over the past year, the R^2 correlation of the SPY and the SPY TLT expectation has been ~.28, which means there can be significant deviations. However, these deviations can be in either direction, and it just so happens that since the debt ceiling deal announcement they indicate more relative selling pressure in the SPY than explained by the risk-off trade. If this continues it indicates a diminished external interest in Treasuries, or a new safe haven for the risk-off trade (gold), or maybe even an increased short interest in the market. In any case, it would not be good for equities if this underperformance persists.
This is a very important relationship to monitor, and understand, if you are going to successfully predict the direction of the market. Continued underperformance of the SPY relative to its Treasury beta expectation would be a bad sign for the markets. Tracking the SPY against its Treasury beta expectation is a good way to normalize Treasury demand for the risk-off trade. Ultimately, if the external demand for Treasuries does collapse, then corporate borrowing costs will explode, and yes, it would be time to panic.
Until then, borrowing costs normalized for the fast-money remain relatively low, so there isn't a great reason yet to believe that the "risk-on" trade won't be back some point soon. Keep an eye on it.