Stocks And Bonds Disconnect; Puerto Rico's Agreement - Bezek's Daily Briefing

by: Ian Bezek


Stocks rallied in the last hour on Thursday to avoid significant losses.

Bonds continue to soar. It is a troubling sign for the equity market going forward.

Congress finally passes a legislation for Puerto Rico's debt situation. What does it mean for investors?

Stocks finally saw a red day after a solid series of wins by the bulls. After a fairly sizable morning sell-off, however, dip buyers took over and pared losses. The S&P 500 (NYSEARCA:SPY) closed off by 4 points, with the Dow (NYSEARCA:DIA) down just 20.

While Thursday's move may seem to be just a pause for the stock market, some other markets are showing signs of a turn. The US dollar (NYSEARCA:UUP) put in a big rally as both the euro (NYSEARCA:FXE) and Australian dollar (NYSEARCA:FXA) got hit by motivated sellers. The Australian dollar is interesting, as it's a key commodity currency that tends to reflect global risk, and its ongoing rally was sharply turned back at resistance.

Long-duration bonds (NYSEARCA:TLT) continue to plow higher. 30-year bond futures are testing new multi-decade highs, and 10-year bonds are back near the highs for the year. The 10-year yield, now down to 1.67%, inspires little confidence that the Fed's hiking agenda has any respect from the market.

Overseas yields also continue to tumble. The German 10-year continues to approach zero - it traded at a positive 0.02% yield on the session. Not surprisingly, European banks are increasingly talking of storing literal paper money in vaults as a way of avoiding a bigger hit if rates continue to decline and the negative interest rate for holding reserves rises additionally.

As a long-time believer in the axiom that the bond market is smarter than the equity market, it does trouble me to see investors plowing into bonds with stocks approaching new all-time highs. It is unusual for both of these to rally to new highs at the same time, and when push comes to shove, bond buying usually signifies a flight to safety.

Yes, there is an argument for buying stocks, even in the face of a global economic morass, excessive valuations, and nonexistent corporate growth. The argument being that equities yield significantly more than bonds, and thus, are a better place to park your money.

However, the spread isn't that great - even if you buy a basket of higher-quality dividend blue chips, your premium to the 10-year US bond isn't much more than 1.5% per year.

I heavily own stocks in my retirement account despite the headwinds for near-term appreciation. However, the mere fact that stocks yield more than bonds is not a sufficient reason to own equities. As bonds continue their stratospheric rise, it concerns me that people are also racing into stocks simply as a yield spread sort of trade.

Make no mistake, having the German 10-year bond at effectively 0% indicates the world economy is in a very unhealthy place. The only way bondholders there make a real positive return is if persistent deflation hits. It's difficult to conceive of a scenario where equities produce a decent return in a persistently deflationary environment.

However, before assuming the bondholders are idiots, it's worth considering that they may be right - as unlikely as it may seem. In any case, in no universe does the huge rally of oil (NYSEARCA:USO) and commodity-related shares fit with the deflationary bust scenario that bonds are increasingly portending.

You're seeing some trades building that are contradictory to each other. The next global macroeconomic shock (either positive or negative) should cause a sharp unwinding of these divergent trends.

Puerto Rico: Will This Solve The Problem?

The US House, after months of debate, has reached an agreement that will try to stabilize the difficult situation in Puerto Rico. The island is on the verge on default, and it's widely accepted that short some sort of federal help, the territory would be unable to meet its obligations.

Republicans, in particular, have been very opposed to a potential bailout for the island, and so, there was a dutiful search to find some other alternative that wouldn't necessarily stick taxpayers with a bill.

The legislation passed on Thursday is a sort of half measure that was viewed, in Republican leader Paul Ryan's words, as a way of reducing the odds that a bailout would be required later in the future.

The bill, after likely approval in the Senate, will create a seven-member board to oversee the commonwealth's financial activities. It takes substantial sovereignty from Puerto Rico. Among other things, it changes the island's minimum wage and overtime laws for federal employees, along with temporarily shielding the island from creditors and granting the right to restructure their debt.

Hedge funds and lobbying groups associated with Wall Street opposed the measure. There are claims that some of Puerto Rico's debts were illegally issued, since they were already over a debt limit, and additionally, that the debts were immune from being restructured.

For investors in troubled municipal bonds, this action leans toward a precedent where taxpayers will be treated better than lenders. That's worth remembering if you want to speculate in Illinois-issued or other such troubled muni paper.

As for Puerto Rico, this appears to be a positive development for the economy, though without any federal funds, it probably won't make a huge difference in the short run.

For investors wanting exposure to a potential turnaround, Puerto Rican banks such as Popular, Inc. (NASDAQ:BPOP) and OFG Bancorp (NYSE:OFG) are obvious ways to invest in the island's fortunes. Another slightly more off the beaten path would be to buy shares in ASUR (NYSE:ASR), the operator of San Juan's airport along with various airports in Mexico. For more on that company, see my recent article.

Personally, I don't see a great deal of upside for Puerto Rico in the short run from this legislative action. It's probably better than nothing, but it's not a great bill either. The island's structural economic and demographic problems still loom large.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.