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Bond Money Finding It's Way Into Financial Equities

|Includes: AIG, SPDR S&P 500 Trust ETF (SPY), XLF

Now that long term treasury yields have risen and broken through significant resistance levels, a lot of money has found a home in the equity market. I believe that the commonplace notion regarding long term bonds being safer than US equities (at every Fed meeting, earnings report, or debt ceiling debate) has been keeping the door open for those still wishing to enter this bull market in equities. It has been a very informative past year for me as a young investor; reading article after article on all major news sites that have helped to propagate the wall of worry for this market to climb.

The news fixated on the following and all the shades between:

  • Earnings collapsing in a dramatic fashion
  • Interest rates rising faster than a growing economy could handle
  • Tax increases, budget cuts, the deficit, debt ceiling etc.
  • Europe never recovering and causing problems worldwide.
  • Chinas slower growth turning into a hard landing for everyone.
  • New record highs matching old historical highs before a crash.
  • The VIX being far too high or far too low to be rationally justifiable.

The flooding into bonds during 2011 was understandable given all the uncertainties the market had been throwing out. However times of high uncertainty can essentially be the best times to start accumulating assets shunned by the many. The US equity market has been inundated with negativity (I was lucky enough to start accumulating US equity positions in late 2012; though not as lucky as others).

Howard Marks puts it brilliantly with an adage for "the three stages of a bull market :

  • the first stage, when a few forward-looking people begin to believe things will get better,
  • the second, when most investors realize improvement is actually underway, and..
  • the third, when everyone's sure things will get better forever."

A question we should ask when determining the safety of an asset class is 'Where does this asset class fit within the three stages of a bull market in the mind of the average investor?'. The inverse logic also holds true in terms of what asset is in a bear market. If your highly thought out and intelligent analysis is shared by the vast majority of other investors, it is quite likely that you're sitting on a market time bomb and a very crowded trade.

I believe that we are entering the second of those three bull market stages for the US equity markets. Why?

If US consumer sentiment is essentially at the same level it was at in 2010, then I believe the majority of investors are still on the lookout for some kind of disaster. However as evidenced by the chart below, US consumer sentiment is still gradually trending higher (albeit slower than expected):

Investors are starting to notice that real improvement is underway, and that the market may be more resilient than the inevitable dramas seem to make it out to be.

Take a look at the progressive steady stream of loans to the private sector:

This is all bullish for continued growth and suggestive of shallow pullbacks in US equities. However if the S&P500 is already reflecting this improvement, then which sector has yet to really take off?

Financials still offer tremendous value, with AIG in particular showing most promise:

Long term value investors would probably love AIG at this juncture. Contrarian investors would love it more so because of the environment in which this opportunity exists (maximum pessimism). With a PE ratio of 11.74, I feel that AIG has yet to reach a level of euphoria with market participants, far from it. The financials remain depressed, however real improvement is underway. Although the S&P500, used as a proxy for the general equity market condition is registering new highs, some sectors like the financial sector have a lot of ground to cover to make up for lost time.

I would be very worried about my positions in the equity market if I started reading lists from major news articles citing the potential benefits of owning equities like the one I've listed above of potential dangers and concerns. Until such a time, I will be long the financial sector and continue to ride the trend for all it is worth.

The most dangerous times to be in equities are when sentiment is at all time highs:

  • the third stage, when everyone's sure things will get better forever.

Until popular sentiment has changed, I am positioned for fixed income finding a home in the financial sector of US equity markets.

Disclosure: I am long XLF, SPY, AIG.