How Stocks and Bonds are Diverging in the Stock Market Melt Up

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Good news for the Aussie economy! Business investment is picking up. Perhaps the mining investment cliff we faced just a few months ago will instead turn into a gentle slope? More on that in a minute…

But first, let’s stand back in awe and gaze at the remarkable, unstoppable run of the S&P500. It’s truly a sight to behold. We now know that the US economy actually contracted in the first three months of the year at an annual rate of 1%. What did the S&P think of that? It didn’t give a hoot…it just kept on marching higher. Who needs economic growth when you have the Fed pumping (diminishing) amounts of liquidity into the markets?

And don’t forget, it was probably just the weather that caused the slowdown, and it only means the economy will bounce back that much stronger in the second quarter, right? Exactly… 

There’s one little problem with the ongoing stock market melt-up. That is, for that past month, 10 year treasury bonds have started to go the other way. You can see this divergence in the chart below. The S&P500 is the red line and the 10-year bond yield is in black.

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click to enlarge

When yields fall (which mean the bond price rises) it usually reflects the prospect of slower economic growth and lower inflation. The current US 10 year bond yield, at around 2.5%, suggests the US is in for a low growth future.

But the S&P500 thinks otherwise.

That’s not to say the bond market is right and stocks are wrong. Back in March last year (see chart), bonds yields fell sharply while stocks continued to rise. Stocks belatedly corrected (following the bond markets’ lead) but then continued on their merry way.

Now, we have the stock market continuing to march higher while bonds diverge. Stocks are saying the economy and profits will grow, while bonds are indicating a slowdown ahead.

The bond market is larger and slightly less emotional than the equity market, so it pays to take heed of its message. In addition, there are a few other signs that aren’t confirming equity market exuberance. 

We’ve marked these signs on the chart above. Firstly, note the falling volume over the past month (the volume bars are below the main chart). Ideally, you want to see a breakout to new highs on rising, not falling volumes.

Next you have momentum indicators at the top and bottom. The RSI index at the top has matched, but not bettered, the previous index highs. On the positive side this index hasn’t been in ‘overbought’ territory for the last few years, indicating the grinding nature of the advance, rather than full blown craziness.

But the MACD momentum indicator at the bottom of the chart suggests this latest rally doesn’t have the same conviction as previous ones. It supports the message coming from the low volume nature of the advance.

There’s divergence going on all over the place, which isn’t usually a bullish sign.

That doesn’t mean stocks can’t continue to rally. But there are plenty of warning signs that a correction isn’t too far away.

Speaking of a correction, a reader writes in with the following question…

As many believe and you point out in your articles, it really is only a matter of time before markets face a minor or more probably a very major correction. It’s just a matter of what the trigger will be and when that trigger will come.

I was wondering then what your thoughts are on what a major correction would do to the price of gold. Would investors move to it as a safe haven and therefore push prices higher or would they run from all investments, including gold therefore pushing the price down. Also, would the price move come from investors moving into/out of gold, or would the majority of the price movement come from speculators and Forex exchanges?

That’s a good question, and we’ll preface our answer by saying we really don’t know. Our answer is simply an educated guess. But here goes…

As we pointed out earlier this week, gold and stocks went their separate ways in late 2012, when the market decided to punt on the relentless monetary infusions from (name your central bank). This punt was a one-way bet, with no requirement for an insurance policy (gold).

If we have a standard correction, we would expect to see a bit of money came back into gold. If there’s some sort of major credit crunch, you could see gold and equities fall together as investors sell good collateral to raise cash. But given the amount of liquidity in the system, this doesn’t seem likely.

The scenario where gold starts to rise significantly is when investors start to worry about systemic risk…which will probably occur with an event that causes confidence in central bankers to wane. As in, ‘maybe these guys really are winging it?’

Clearly, we’re not at that point yet. This is why gold remains in a three year bear market and stocks are at record highs, despite weak economic growth and a bond market signalling things aren’t getting better anytime soon. But things could change quickly. Confidence is fleeting…

There is a massive central banker premium built into stocks right now. Conversely, there is a central banker discount built into the gold market. Selling the premium and buying the discount will be a good long term bet. But you may have to endure going against conventional wisdom for another, two, six, or 12 months…or maybe even two more years, who knows?

Remember, markets can stay irrational longer than you can stay sane.

That this will end in a disaster is not in doubt. How and when it will end, and with how many people on board and believing in it, is the big question. Prepare to have your emotions tortured and your deepest convictions tested…

But let’s not end the week on such a foreboding note. After all, a rare bit of genuine good news arrived for Australia yesterday in the form of a capital expenditure survey which showed businesses plan to increase their investment spending nearly 10% more than they thought three months ago.

This is good news, because the last survey showed that Australia faced a very big drop in investment in 2015 following the end of some major LNG projects this year. Residential housing investment was picking up, but not enough to offset the large fall in mining investment.

However, yesterday’s survey suggests the increase in investment intentions is picking up, with the ‘services sector’ becoming more optimistic.

That’s good news, and means the RBA will be firmly on hold regarding interest rates, probably with a bias to raise them should more strong data emerge in the coming months.

But keep in mind these are only intentions. The increased spending plans from the services sector undoubtedly reflect an increase in activity from the RBA’s interest rate cutting cycle, which occurred from late 2011 to August 2013. The effects of the stimulus have largely washed through the economy (and housing market) now.

The bullishness from (specifically) the services sector reflects the strength of activity earlier in the year, but it will be interesting to see if these spending intentions convert into reality. House price gains have now started to slow and the budget managed to dent whatever confidence was emerging during April and May.

We’ll give it the benefit of doubt…for now.

Regards,

Greg Canavan+
for The Daily Reckoning Australia

Join The Daily Reckoning on Google+

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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3 Comments on "How Stocks and Bonds are Diverging in the Stock Market Melt Up"

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Harquebus
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‘maybe these guys really are winging it?’ No ‘maybe’ in it mate. Energy fuels the economy and oil drives it.
Contrary to what most economists believe, economies do not grow themselves. Economies grow by using cheap and abundant energy to turn raw materials into finished products while trade depends on transport depends on oil.
Has anyone seen any cheap and abundant of either lately.
Bang or whimper, it is unavoidable. The era of economic growth is over. Peal oil mates, peak oil.

slewie the pi-rat
Guest

short both the S&P AND Treasuries and get a nicely ‘hedged’ bet down on convergence, now that the prior ‘hedgers’ have had their freaking faces ripped off by the divergence?

here’s a better bet:
next week, slewienomics will have another $99 Special Report:
“Why Deflators Are Inflating: Transitory, Transpersonal, or Transsexual?”
PLUS! the Stanley Cup Winner! GUARANTEED!!!
PLUS! a testimonial from one of my regular readers, Dr. John Hussman!

Jason
Guest

The journalists and politicians and economists can bang on about ‘growth’, but the day will come when oil production peaks and falls and growth will end.

wpDiscuz
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