How Stocks And Bonds Can Both Rally On Nothing

Includes: DIA, IWM, SPY, TLT
by: Kevin Flynn, CFA


Short positions in stocks and bonds have been fueling prices.

The same economic data feeds different biases.

Equities remain vulnerable.

Probably the most important thing that you need to know about the recent rally in equities is the NYSE short position report dated May 15, 2014 (compiled and released semi-monthly). It showed short interest to be at a three-year high (at least; it's as far back as the non-subscriber report goes). Traders were loaded for bear, and when one didn't arrive, ended up having to use their ammunition to cover. There was no catalyst for the widely-bruited correction, but a kind of reverse catalyst - no bad news - for our little melt-up.

Let us now switch over to the Treasury market, where a rally has caused no small amount of consternation in recent weeks. The yield on the ten-year Treasury bond fell to 2.44% on Wednesday the 28th, a low going back to last June. James Bianco of Bianco Research has observed several times in recent weeks (I regret to say that I was unable to track down a clip to link to) that one of the reasons for the fall in yields was that "the whole world" was short Treasuries at the end of last year, because everyone knew rates were going higher (certainly I can attest to it being the prevailing sentiment at the time).

The situation has been aggravated by the falling deficit - although the Fed has been cutting its purchases of Treasury bonds, issuance has fallen even faster. According to Deutsche Bank, net Treasury issuance is down 59% from a year ago. So even though the Fed is buying less in dollar terms, it is buying more in percentage terms - about nine-tenths this year, according to one graphic I saw, compared to just under two-thirds a year ago.

In equities, there has been no catalyst in the last two weeks to drive prices lower, a point I have been making in this space. The data has been rather weak, but since it has been beating estimates it is being positioned as strong. Equally, there has been no catalyst to drive bond yields higher (and prices lower). With bond fund inflows running around double the size of equity inflows (cf. the Deutsche Bank link above), the supply/demand situation is favoring lower yields and higher prices.

It is often said that the bond market is smarter than the stock market, because it is a better predictor of the economy. I put this in italics because some equity traders muddy the issue by substituting stock prices for the economy and then claiming that the bond market has been wrong. But the bond market doesn't predict the stock market, it predicts the economy, and on that score it has been right: real GDP declined from 2.8% in 2012 to 1.9% in 2013, while the price deflator has fallen for three years in a row, from 2.0% in 2011 to 1.5% in 2013. Thursday's revision of first-quarter GDP is expected to show a decline for the first quarter.

Similarly, the well-known Citigroup economic surprise indicator does not predict the economy either - what it really predicts is short-term stock prices. This is because the bond market prices from the data itself, rather than whether or not they beat estimates. The stock market is the exact opposite. Two good examples are the recent data in new home sales and durable goods.

The bond market and propeller-heads like me see the new home sales data and note that April sales were lower than a year ago, and that year-to-date sales are running behind 2013. The stock market sees the increase from March to April and an upward revision to March (a result of shuffling 3K in actual sales from January/February to March, leaving first-quarter sales unchanged). The business news and talking heads start rhapsodizing about "spring momentum" in housing and filling the news flow with positive phrases. These words are read in turn by black-box trading programs that analyze the feed for positive and negative-quality words and then trade accordingly. Result: More buying.

In the bond market, you get rewarded for being right about the economy and inflation; in the stock market you get rewarded for being right about the stock market. I don't say that to be cute: The truth is that equity prices will track the economy in the long run, but can detach from economic fundamentals for long periods. It should also be noted that both markets are engaged in a certain amount of wish fulfillment - after all, as a rule bond prices go up when the outlook is weak and stock prices are up when it's strong, so both sides have a vested interest in a certain perspective.

In either asset class, stocks or bonds, one ignores supply and demand dynamics at his or her own peril. However, supply and demand factors do not exist in vacuums either, and are prone to being shifted by fundamental currents in the economy. One can argue for hours about whether or not the reduced issuance and short positions in the Treasury market will be able to drive yields down to the 2.25% level, and for days about how much of it is distorted or temporary due to supply and demand mix, versus the bond market pricing in (or not) a global slowdown. I would say that unless you are actively trading bonds, the one firm conclusion that you as an investor should concern yourself with is that the Treasury market is not pricing in a growth breakout. That's not to say one can never happen, only that one isn't justified from current data.

Quite simply, bonds have lacked a genuine upside growth scare in recent weeks, while equities have lacked a genuine contraction scare. For lack of anything else to do, the short positions on both sides are getting squeezed, helped along by some typical short-term momentum trading. I'd be careful about reading too much into either asset class situation. The bond market's track record suggests it has a better insight into the next quarter of growth than the stock market, and here I would agree, but that doesn't guarantee anything for stocks.

One of the better-known stock gurus was rhapsodizing about the bull market on Tuesday, yet bitterly reproaching cynics on Wednesday after the merest of pullbacks. I bring it up not to call anyone out, a practice I generally dislike, but because he went on to add that "the recent data away from [bond] rates involving durable goods, autos, industrial production and electrical power generation [are] just way too strong (my italics) for anyone rigorous to conclude that rates are declining because the economy is slowing." I beg to differ, and also offer it up as an illustration on the different perspectives that bond and equity traders bring to the party.

Although I don't track electrical production, I do track the other three categories. Auto sales are the best of the three - the year-on-year increases have been stable for about three years now at roughly 10%. This is a remarkable run, the longest in the history of Commerce Department data. All I can say is, beware of predictions of any new "permanently high plateau." The rate is not sustainable.

So far as durable goods go, the data are definitely not strong. Durable goods are a very lumpy category, distorted by vagaries in military spending and airplane orders that may or may not ever get delivered. Given Boeing's (NYSE:BA) wait times, for example, a new $20 billion order may get added to the Commerce Department's monthly report, but with Boeing's full order books and long lead times, it would mean practically nothing to current production levels. Indeed, I would add that new orders booked today are at more than usual risk for cancellation, given the age of the business cycle and the fact that orders are routinely canceled or indefinitely postponed during slowdowns.

Airplanes and defense business gave the latest monthly report for new orders a positive surprise, and changes in seasonal adjustments led to outsized positive revisions. Like many others, though, I use the business cap-ex category instead ("non-defense orders excluding aircraft") to measure economic strength. Because orders are so lumpy from month to month, I measure the growth rate for twelve-month new orders over a two-year period. It's been a much better indicator of where the economy is headed than short-term monthly twists and turns (though if monthly orders were to fall to zero, I would sit up and take notice). Through April of 2014, the compound annual growth rate for the trailing two years declined to 2.3%, the lowest it's been since May 2011. It was still rebounding at that time from the recession; the last two times it declined to that level were October 2008 and May 2001.

A simpler way to look at it is that April 2014 was up 3.5% from April 2013. That compares with year-on-year rates of 4.5% in April 2013, 7.0% in April 2012 and 13.3% in 2011.

The industrial production data is similar. The year-on-year increase in April 2014 is currently pegged at 3.2%, according to data from the Federal Reserve. In April 2013 it was at 3.1%, in April 2012 at 4.6% and in April 2011 3.7%. I believe that "rigorous analysis" does not qualify this data as "way too strong."

Nor is it way too weak, though I must confess that the data for cap-ex new orders worries me. But it does illustrate how the bond market can crunch the data and see one thing, while the stock market, dominated by estimate "surprise" deviations and the latest monthly "trend" sees another. The stock market has always been dominated by momentum traders, and probably always will be.

You may have noticed a prediction floating in the news recently that stocks were about to correct 25%. This misquote has been taking a terrific beating in equity-land the last few says, concurrent with the four-day rally in equities that surely must presage a breakout to ever-greater things and put to rest forever the adage about "sell in May and go away."

Beware. Noted technician Ralph Acampora did not propose a 25% correction in May. He suggested that a 10% correction in the S&P 500 could come between mid-May and October, which he thought in the case of some of the more volatile sectors like small-caps, might stretch to as much as 25%. He then proposed a fresh rally would follow.

I wouldn't go so far as to call the overly dramatized follow-up in the media (replete with triumphant rejection, as evidenced by stock prices) as being staged, but you should be aware this kind of stuff does get routinely and aggressively promoted by certain birds of prey hoping to flush out the more excitable sort of small game.

Apart from the short-covering and a very mild dose of momentum, the one real thing equities have on their side at this time is the hope that ECB President Mario Draghi is about to announce some fresh wave of accommodation from the bank that will set off another follow-on wave of sentiment that central banks are the guardian angels of stock prices. That and the fact that they are still only moderately overbought. This rally is no precursor to a big melt-up, but a lovely chance to scale back on some positions while the going is good.

Disclosure: I 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.