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Wall Street tends to segregate “bond-guys” from “stock guys”. The bond side of the market tends to be more conservative; they also perform more detailed research, meaning they actually look at the numbers. The stock side of the market is based more on momentum, gut feel, and stories.

The current stock market story is that the problems in Europe have been solved. The bond market does not share that bullish sentiment. On Friday morning, the yield on a 10-year Italian bond moved back above 7%. The stock guys will say “so what, countries have survived with higher yields.” That’s true, but the yield is only one of the factors; you must also consider the size of the country’s debt, their revenues, and the size of their banking system. The size of the banking system is relevant in the event the government needs to bail them out and/or recapitalize them.

10 Year Italian Bond Yield

From Bloomberg (12/23/2011):

Prime Minister Mario Monti’s market honeymoon is ending as Italian bond yields approaching 7 percent signal mounting concern his government may struggle to sell 440 billion euros ($574 billion) of debt next year.

“The Monti effect has now also been priced in and I think there is a lot of room for disappointment next year,” said Lex Van Dam, who manages $500 million in assets at Hampstead Capital LLC in London

“The structural reforms are regarded by the market as more important than the budget measures,” said Stephen Lewis, chief economist at Monument Securities Ltd. in London. “Because these structural reforms impinge on special interest groups, Monti will face strong opposition, possibly on the streets, but definitely from politicians representing those interests.”

To understand the scope of the current problem, the following questions are addressed at various points in this December 18 video:

  1. When does debt become unsustainable? See 00:29 mark in video.
  2. How can rising yields create a crisis so quickly? 13:30 mark.
  3. Why have the financial markets been so volatile? 21:37 mark.

The stock side of the market likes the “Santa Claus rally” story (it requires little effort). Therefore, we cannot rule out a push as high as 1,340 in the S&P 500 over the next few weeks. However, the bond market’s fundamental analysis will most likely, in the end, prove to the stock guys the problems in Europe are not solved.

Longer-term, we will continue to favor deflationary assets, such as cash, conservative bonds, and inverse stock positions/shorts (NYSEARCA:SH). If the euro (NYSEARCA:FXE) cannot muster a short covering rally soon, we would also consider adding to our relatively conservative position in the U.S. dollar (NYSEARCA:UUP). If stocks break above the S&P 500’s 200-day (now at 1,259), we may take on a small hedge (NYSEARCA:IJR) to offset our exposure to deflationary assets. For now, our largest position is cash.

Disclosure: I am long IJR, SH, UUP.

Source: Bond Market: Europe To Remain Problematic For Stocks In 2012