Hide Under A Rock And Inflate The Bond Bubble

by: Nigam Arora

The old wisdom is that fear and greed drive the markets. Now the crowd is acting out of fear, hiding under the rock and buying U.S. Treasury bonds.

The crowd is usually right but at the extremes the trade is to go against the crowd. Are markets near an extreme in bonds, stocks, oil, and gold? This is the key question facing investors.

Technicals And Fundamentals Diverge

CBOE Interest Rate 10-Year T-Note (^TNX) chart illustrates the technicals.

The chart covers a 50 year period. In technical analysis there is nothing better than 'trend is your friend.' The trend in yield is down and some are now predicting that the yield will fall to 1%. The yield has made a significantly lower low than the low of the financial crisis marketed on the chart. Although not the bench mark behind poplar bond ETFs, the index shown in the chart is the driving force behind popular ETFs such as (NYSEARCA:TLT), (NYSEARCA:TBT), (NYSEARCA:TBF), (NYSEARCA:TIP), (NYSEARCA:TTT), (NYSEARCA:TPS), (NYSEARCA:TLO), (NYSEARCA:TLH), (NYSEARCA:TBX), (NYSEARCA:TBZ), (NYSEARCA:LQD), (NYSEARCA:JNK), and many others.

On Friday June 1, 2012 the U.S. stock market broke the 200 day moving average. Those who believe in the magic of 200 day moving average started panicking and selling. Broad stock market ETFs including (NYSEARCA:SPY), (NYSEARCA:DIA), (NASDAQ:QQQ), and (NYSEARCA:IWM) plunged. Investors sought the safety of precious metals; gold ETF (NYSEARCA:GLD), silver ETF (NYSEARCA:SLV), gold miner ETF (NYSEARCA:GDX), and several major precious metal miners such as (NYSE:ABX), (NYSE:NEM), (NASDAQ:PAAS), (NYSE:SLW), (NYSE:CDE), and (NYSE:GG) spiked up. On Monday June 4, 2012, the trading was volatile but did not advance the cause of bulls or bears.

There is nothing intrinsically magical about the 200 day moving average. The 200 day moving average derives its power only because a large number of market participants have bestowed the power of deciding bull and bear markets on this average. They consider it a bull market when the market is trading above the 200 day moving average, and a bear market when trading below the 200 day moving average.

Bond Fundamentals

U.S. national debt is $15.76 trillion or $138,577 per taxpayer. U.S. unfunded liabilities not included in the national debt are Social Security in the amount of $15.71 trillion, prescription drugs in the amount of $20.78 trillion and Medicare in the amount of $82.64 trillion. Total unfunded liabilities are $119.13 trillion or $1,047,713 per taxpayer.

U.S. federal budget deficit is $1.41 trillion.

Inflation is running at about 3%.

If the U.S. government was a private corporation, it would be insolvent. There is no fundamental case for lending to an insolvent borrower at 1.47% for 10 years. The bubbles form because those making the bubbles bigger are fully convinced of the arguments in favor of the bubbles never busting. Treasury bonds are in a bubble. Now out of fear investors are further inflating the bubble.

Stock Fundamentals

From a fundamental point of view, the bond yields are signaling a depression. However, corporate earnings are still growing although earnings forecasts are deteriorating. Even the deteriorating forecasts show growth in earnings.

The stock market is not expensive. The S&P 500 is trading at a P/E of 12.9 compared to 15.9 at the beginning of last year.

Investors are spooked that May non-farm private payrolls climbed by only 82,000 far less than the consensus estimate of 168,000.

I have been writing for some time that there was growing discrepancy between the employment data and the GDP data. Assuming no change in productivity, an extrapolation of the employment data showed that the GDP should have been growing at about 4%; the GDP data showed it was growing at about 2%. The two pieces of data could be reconciled if productivity was falling.

The anecdotal evidence did not support falling productivity thesis.

The employment data just released resolves the conflict. Employment is simply not growing as fast as the data at the beginning of the year showed. After crunching massive amounts of data, we have come to a very simple conclusion.

It turned warmer much earlier this year. Warm weather resulted in spiking employment and the spike was taken by some as a sign of strength, now the employment growth is back to what is to be expected with a 2% GDP growth. This means that the panic over Friday's employment numbers is senseless.

Time To Go Hunting

Markets move based on information that is not yet known. The problems in Europe and slowing growth world-wide are now well known. What is not well known is that Spain and Italy may start improving, central banks may act forcefully, and European leaders may finally come together to make progress towards fiscal integration.

ZYX Global Multi Asset Allocation Model anticipated the current downdraft in stocks and depending upon its usage is now 41% to 58% in cash. The model is now calling for stepping up to the plate and cautiously buying assets that have become cheap and shorting assets that have become expensive due to the overwhelming fear. Before you dismiss this model consider that in the 2008 financial crisis, the model generated 42.90% positive return compared to a loss of 36.10% loss in the S&P 500.

Disclosure: I am long QQQ, CDE, TBF, PAAS.

Additional disclosure: I, my hedge fund, and subscribers to The Arora Report are following the strategy outlined in the article.