Investor Fear Creates a Mad Dash for the Bond Market

You don't often see yields on three-month U.S. Treasury notes fall by 66 basis points in one day. Then again, in polite (or even impolite society) the yield on three-month Treasury notes is not a subject you'd willingly bring up-unless you wanted to make a spectacle of yourself. But financial panics can bring even obscure subjects to the lips of an everyday punter.

The flight to cash has been more like a mad rush for the last two weeks. "The market is totally, absolutely, completely in fear mode," according to John Jansen. Jansen's been busy lately selling Treasuries for CastleOak Securities LP in New York. Earlier this week he told Bloomberg that, "People are afraid that lots and lots of mortgage paper and mortgage paper derivatives of all sorts is completely opaque and they can't price it."

Three-month U.S. Treasury notes are sort of like cash. If you were moving your money out of a short-term money-market account, and were looking for what's traditionally been a safe place, this is where you'd park your dough. Bond yields and prices move in opposite directions with Treasuries. Falling yields meaning rising prices. Rising prices mean rising demand. It follows that dramatically falling yields on the bond market mean dramatically rising prices. There's a mad dash to get to cash.

For the record, the fall in three-year Treasury yields earlier this week was the biggest one day fall since 1987. You might remember that year. On October 19th of that year the Dow fell by 22%. The ASX opened the next day at 2,052. It closed at 1,549. That 500 point drop equated to a 32% fall-in one day. It got worse from there, with the market closing as low as 1,151 on November 11th. That was your dip-buying opportunity.

The point of this quick trip down memory lane is that the bond market hasn't been this panicky since the stock market last crashed. Only we haven't had a crash this time around. Just a correction. Treasury yields rose today as prices fell. That means there was a bit less panic in the dash for cash. But there's no doubt investors are still nervous. They're nervous because no one knows if it's safe to go back in the water again and buy the kinds of asset-backed securities everyone's been buying for the last five years.

The Fed next meets on September 18th. The cadre of brokers, lenders, and financiers who engineered the whole mortgage bubble in America (and securitised and sold it to European banks and Australian hedge funds and local councils) desperately hope Ben Bernanke will take them off the hook and make it all go away by cutting rates.

September 6th might be a much more important date, though. That's the date the European Central Bank meets. The ECB has indicated it intends to raise rates in Europe to 4.25%. Whether it will do so in light of the recent disaster in financial markets is another question. If it does, all hell is going to break loose for the U.S. dollar. That's where we'd expect to see a big move in gold and oil.

Be careful about using low P/E ratios as a buying indicator. We read in this morning's paper that the average P/E on the ASX 200 is the lowest its been in 12 months. That doesn't automatically mean stocks are "good value." In fact, in the past, low P/E ratios have been a sign of the market top. Why?

At the height of an economic cycle, corporate earnings are high. When earnings rise faster than share prices, the P/E ratio will look low, flashing a "buy" signal. But this may be just the time that earnings themselves have peaked. That's definitely not the time to buy a stock.

It's probably a better idea to treat the stock market as a market of stocks. You go to the grocery store because you need food. But you don't buy one of everything because food prices look like good value. You buy particular value where you find it. And, if you're like us, you buy blueberries because of their anti-oxidant qualities. Blueberries have been awfully expensive lately, though.

What businesses or sectors have the ability to grow earnings in the next year? We noted in our weekly update to readers of Outstanding Investments that coal and iron ore prices are again going up. The question with resource stocks now is if price increases in the underlying commodities will eclipse wage and energy cost gains. Again, you take it on a case by case basis.

Dan Denning
The Daily Reckoning Australia

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