Where Do We Go From Here?

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Includes: SPY, TLT
by: Ron Honig

Summary

The markets are expressing signs of nervousness.

Correlation between stocks and bonds markets are changing it course.

The markets behavior during the last decade can give some clues about the direction we are heading.

It has been almost seven years since chairman Bernanke took the Fed's interest rates to all time lows. A record that was followed by three waves of quantitative easing, which drove huge amount of cheap money into the markets. Below is a graph that shows the U.S interest rates over the last twenty five years. We have hit the bottom.

Source

During the period of "cheap money" both the stock markets and the bonds markets did very well. Below is the a five years graph that compares the behavior of the SPDR S&P 500 ETF (NYSEARCA:SPY) to the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT).

During that five years' time frame, going from Q2'10 to Q1'15, the 20+ years bonds went up by more than 40% while the S&P500 went up by more than 70%.

While examining the trend of these two vehicles we can see that each holds a different pattern. While the TLT has been fueled by declarations on quantitative easing programs and faced some decline afterwards, the stock market kept on moving upwards in a very consistent fashion with minor corrections along the way.

Let's examine the correlation between the 20+ Bonds and the S&P500 during that five years' time frame. Looking at the next graph it is clear that most of the time the correlation between these two vehicles was negative.

During 2010 the 2nd QE was announced and in 2011 during the U.S credit downgrade crisis and the euro debt crisis led investors to flee to bonds as it was seen as a solid alternative to the volatile stock markets. During those years the correlation between bonds and stocks was a strong negative one.

Towards the 3rd QE that was announced in 2012 the negative correlation became less significant as the QE drove the bonds market upwards and to all time low records on yields, which led a huge amount of money to look for some yield elsewhere. Most of the money was shifted to the stock markets with a hope to achieve some positive returns.

The U.S macroeconomics improvement in 2013 fueled the stock markets yet again but led to concerns that an interest rate increase is coming. This had a negative impact to the bonds market and therefore we see a negative correlation between the two markets during that year.

2014 was quite unique as the correlation between bonds and stocks became positive. Concerns about a raise in the interest rate impacted both markets at the same direction. Cheap money fueled both markets in parallel leading both to all time highs.

External events impacted the trends as well. A good example is the Russian economic crisis that hit last December following the drop in oil and gas prices that had an impact in the U.S. Yet again we saw the stock markets making a short term retreat while the bonds markets reaching higher to low yield levels.

The next graph shows the same SPY to TLT five years comparison with the main milestones stated in it:

So, what could be next?

As we moved into 2015, we see that the positive correlation is changing its course. The big question is whether these two vehicles can maintain the positive correlation between them throughout the year or whether we are moving towards a neutral or even towards a negative correlation territory.

In order to assess this question let's enlarge the perspective and examine the correlations between the S&P 500 and the 20+ years bond market starting mid-2002.

In the next graph, where that is shown by the blue correlation line and in orange the FED's interest rate, we can see that positive correlation was held for short periods of time. For example the 2004/05 stock markets recovery was accompanied by an increase in interest rates, which negatively impacted the bonds markets.

The 2013-15 graph is very similar to the situation in 2002-2004. Low interest rate that at some point will start climbing upwards and correlation will crawl down to neutral or negative in the short-mid-term.

Now, one should remember that the two markets are not symmetrical in term of potential gain in the long term. The bonds are capped by the yields that it hold, meaning that a 10 years Treasury bond with a 1.87% yield has the potential to go up by up to ~19% (1.87 yield x 10 life expectancy). If an investor is not planning to hold the bond until fruition there is a high risk of capital loss in the event of an interest rate increase. So even if you are positive about the bonds markets you need to remember that it cannot climb forever.

Assuming that we are trending back towards a neutral-negative correlation territory, here are the potential scenarios that an investor should consider:

  1. The stock markets go up while the bonds markets are flat to down.
  2. The stock market go down while the bonds markets are flat or up.

What could trigger an "A" type of scenario?

Nowadays the markets are at all time highs due to lack of a solid alternatives and due to high earnings expectations that are built into high P/E ratios.

If during the earnings season many companies beat expectations then the stock markets will continue moving upwards. A positive earnings season will make it easy for the FED to increase the interest rates during the second half of the year, and this would lead to a negative response in the bonds markets.

What could trigger a "B" type scenario?

If the earnings season continues to be pale, then the stock markets will need to adjust the prices to modest growth expectations. This would mean a pullback in the stock markets. The question is what would be the implications on joblessness and job creation indicators. If the job creation is severely impacted it will impact the FED's decision to postpone the interest rate increase and that would positively impact bonds markets, at least in the short-medium term.

My personal perspective

In previous articles I explained why I am less optimistic about the short term earnings season. The dollar/euro situation, energy prices swings and too high growth expectations might lead to a short term pullback in the stock markets. Volatile markets would lead to lower bonds yields hence the bonds markets would not suffer, at least in the short term.

On the mid-long term I am optimistic about the big cap companies. Corporations with significant amounts of cash will be able to come out stronger from this cycle following the ability to do mergers and acquisitions and pursue organic growth.

On FED's interest rate, I expect a small increase during the second half of the year. Though it would probably be small and not a significant one, the FED would need to keep up with its commitment and declare an increase by end of year.

Based on these assumptions it would mean that the correlation between the two vehicles of stocks and bonds will diminish in the short term and become negative in the mid-long term.

So what am I planning to do?

I will patiently wait for the stock market pullback to take advantage of the volatility and continue my strategy to pick up dividend champions for my 4% dividend yield portfolio. I will also look for opportunities to take advantage of the expected interest rate increase in the second half through leveraged vehicles which I will cover in my next article.

What are your expectations?

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.