Who's Right About Europe? European Bonds Or U.S. Stocks?

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Includes: DIA, FXE, QQQ, SPY, VGK
by: James A. Kostohryz

Let’s be clear: In the medium term, the direction of the stock market (^GSPC, ^DJIA, ^IXIC, ^NDX) has been and will be dominated by events in Europe. This is as it should be, as I pointed out here.

Many would prefer the direction of the U.S. equity market to be determined by buoyant third quarter earnings or better-than-expected economic data in the U.S.

But the fact of the matter is that if Europe goes down, the entire world including the U.S. is going to suffer major consequences no matter what near-term and backward-looking data register.

Can the prices of European bonds and/or U.S. stocks (DIA, SPY, QQQ) provide us with any clues about what is ultimately going to happen in Europe?

Divergent Expectations

The S&P 500 has recently been trading in a wide trading range between around 1,250 and 1,075 on the S&P 500, with stock positioning themselves within this range as a function of expectations regarding outcome of policy decisions in Europe. With equity indices currently trading at the upper end of their ranges, U.S. stocks seem to be discounting a relatively high probability that the resolution of the situation in Europe will be favorable.

The sovereign bonds of the key European countries that are at the heart of the crisis have also been trading in a wide trading range during the past few months. However, they are reflecting an entirely different set of expectations regarding the probability of a favorable resolution of the European crisis.

For example, U.S. stocks have zoomed upward by well over 10% since October 3. However, Italy’s 10Y bond is trading at a yield of 5.8% versus a level of 5.45% on October 3rd. Spain’s 10Y yield is at 5.5% versus 5.12% on October 3rd. France’s 10Y yield is trading at 3.22% versus 2.62% on October 3rd. All of these yields are at the extreme tops of their recent trading ranges - reflecting substantial pessimism regarding the outcome of the European summit.

Thus, with U.S. equity indices at the top of their recent trading ranges and the price (inverse of the yields quoted above) at the bottom of their recent ranges, there is a clear divergence of expectations between these markets.

Which market will prove more prescient?

Informational Value Of Market Prices

Market prices can contain valuable information. Some market prices have a track record of acting as leading indicators. This may be due to informational and/or knowledge asymmetries. Prices in some markets may act as leading indicators due to the fact that participants that set the prices in those markets may be particularly attuned to information and knowledge that is later disseminated to other markets.

This may be one reason why “Dr. Copper” has proven to have a fairly good track record of “predicting” economic and market cycles. It may also be the reason why bond markets are often the first to pick up on major turning points in the business cycle.

Based on this framework, one would have to give a “hat tip” to the informational value being provided by the prices of European bonds. The marginal participant in these markets (price-setters) should probably be much more attuned to the political, economic and financial situation in Europe than marginal traders (price-setters) of U.S. stocks.

Having said this, there is no certainty provided by this insight. It may mean nothing more than to say that in a model which tries to predict the outcome of European affairs, the educated guess of the marginal European sovereign bond trader should probably be accorded a higher weighting than the educated guess of the marginal U.S. stock trader. That is not a fancy financial insight. That is just plain common sense.

However, so as we contemplate the informational value that can be derived from European bond prices, let us not forget: At its core, we are talking about more or less educated guesses – with emphasis on the word guesses. Nobody knows exactly what European leaders are going to do. I don’t think that European leaders themselves even know at this late hour what they are going to do.

Conclusion

The divergence in the prices of U.S. stocks and European bonds probably does not provide a sufficient reason to short global equities. Given the high level of uncertainty surrounding what European governments are ultimately going to do, the predictive edge offered by the divergent perspectives manifest in European bond markets and U.S. stock markets is probably not sufficient to hang a hat on.

Having acknowledged this, I think that at least this much can be said: The recent rally in U.S. equities provides no reason to become optimistic about the medium term outlook for the U.S. and global economies and financial markets. The direction of global markets in the medium term will be determined by events in Europe. And in this regard, if the outcome in the medium term turns out to be unfavorable as I expect, the collapse of global equity markets will only be more severe.

The portfolios I manage are more or less flat in terms of equity exposure, with a modest bias to the short side via the leverage provided by puts. Why?

Straight short-side exposure makes little sense in this environment in which short-term risks and rewards are more or less symmetrical. Straight short sales (or longs, for that matter) would only really make sense after the policy announcements, if they turn out to be unfavorable. Indeed, with the market at current levels, short-sellers can still get a reasonable short-side entry, even if the market were to gap down 3%-4% in the immediate aftermath of an announcement.

By contrast, put options are a viable strategy on the short side in my view since risks are discontinuous and asymmetrical. A situation like this is where the special characteristics of options can be put to good use.

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