Bonds May Not Be Tops, But No Need to Sell Just Yet

by: Finance Banter

All that seems to be missing from last week’s market was a bottle of champagne to christen the beginning voyage of QE II. Given the success of the first go round of quantitative easing (QE I), expectations are beginning to grow that this could be “the one” to finally get the moribund economy growing.

What has the markets frozen in their tracks is reconciling the economic data (a bit better than expected, but nothing to write home about) and the Fed outlook (less than desired growth and inflation). Comments by Fed governor Dudley last week indicated that an announcement would be forthcoming at the November confab.

Playing a game of chicken with the markets, anything “less than expected” from the Fed regarding QE II could send equity markets lower. The financial markets have been rising, expecting to see additional money flowing from the Fed into the financial system; unfortunately that money is not flowing to areas that it actually is needed.

The big economic report is due on Friday: Unemployment. Expectations for zero job gains is fueling expectations that the Fed needs to do something, anything, to get growth high enough that corporations will begin hiring.

Closing out the best September since 1939, the quarterly gain of over 11% was the best since the bounce from the ’09 lows and with expectations high for more monetary stimulus and decent corporate earnings, investor sentiment is relatively high and leaves ample room for disappointment at least through the early part of the fourth quarter.

The saving grace for the markets is the number of advancing to declining stocks (market breadth) has been very positive and continues to march higher. This may be a result of investors piling into index funds of all varieties and not focusing in on individual stocks, but whatever the reason, stocks are rising.

As a result of the gains of the past six weeks, the markets are now sitting near some technical resistance levels (1150 on the SP500) and momentum indicators are at very high levels that usually indicate at least a correction in stocks is ahead. Whether modest or more significant is hard to say from here, but given the run, a modest decline is most likely for October.

The Fed activities in the bond market, buying Treasury bonds to inject cash into the financial system, is creating steady demand for Treasury bonds and effectively putting a floor under prices (and a ceiling to rates). The buying activity has also had a secondary effect of making bonds much more volatile that otherwise would be the case. The 10-year bond has been bouncing between 2.4% and 2.7% over the past two months depending upon whether the Fed is active or not in the markets. Pushing rates higher are concerns about the Fed’s activities to increase inflation at all costs. This is also pushing the dollar lower in foreign exchange markets, making our goods cheaper to buy around the world, but making foreign goods (and travel) more expensive – effectively raising inflation for those goods.

The semi-regular look at the major asset classes once the month ends is very interesting this month, as for the first time all year, bonds are no longer among the top performers. Even with lower interest rates, the gains in equities over the past quarter far outdistanced those in bonds. Whether that reversed in October is up for debate, however since I use a trend following model, at least for the next month equities will be highlighted.

From a historical perspective, stocks may be under some pressure early in October, however in mid-cycle election years since 1952, the period from October to April is the strongest in any period within the four-year election cycle. This doesn’t mean the markets will race, but there is a tendency for strong markets through the first quarter of next year. A “normal” yearly cycle also shows a tendency for strong markets from November into May (then is the sell in May and go away mantra). So given a change in the asset class rankings toward equities, a stronger period in the calendar and promises from the Fed of more money flowing into the financial markets, we could indeed see fireworks from the markets over the next six months.

Given the run of the past six weeks, we could see stocks meander or decline over the next week or two to work off some of the excess enthusiasm built up over that period. Having made it through the worst part of the financial calendar unscathed, buying stocks over the next few months may be very profitable. The unemployment report on Friday and the beginning of earnings season could be the reason for a market decline in the next week or two. Bond investors should hang onto holdings for now, although I may sell some of the shorter maturities and use the cash for equity investments.

Disclosure: None

Disclaimer: The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.

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