Today's downside action really didn't do much damage to the uptrend. Further warning signs however are evident. The Nasdaq which has been one of the leaders of this advance is lagging significantly and more importantly, bond yields are spiking which could be a warning sign of an immanent IT top for equities (more on this below) A lot of bears are ranting about how there was a failed auction for bonds that caused this spike in yields. That may be true but I think it was just acceleration of a trend already in place which is being driven by a decrease in risk aversion from institutional investors and a higher expectation of inflation due to economic growth. For instance, CPI and PPI stats were signaling deflation earlier in the year and so I don't think it was a coincidence that bonds rallied fiercely several weeks prior to this data coming out. For the last several weeks whenever equity markets rallied bonds typically sold off and when markets tanked bonds rose. Thus, it seems evident to me that the driving force of bond prices are expectations of higher inflation due to economic growth and a decrease of risk aversion NOT the hyper inflation economic collapse scenario because if that was the case, the US dollar and the equity markets would have been in the toilet along with bonds. Perhaps bonds will start selling off due to this Armageddon scenario one day but I don't buy that at this time.
One thing I have noticed is that at previous IT tops during this bear market and the last, they coincided with a spike in bond yields. Thus, the spike had a tendency of choking off the equity rally (perhaps as a result of the negative impact of higher borrowing costs, better valuation vs. equities...whatever.... all I know is that this has been a pattern). It was also common to see equities begin to roll over and bonds still continue to sell off for a while (probably due to a further but unwarranted decline in risk aversion) but eventually bonds would begin to strengthen as risk aversion picked up and expectations for growth were ratcheted downward.
Thus the behavior of bonds and its impact on the markets can be quite interesting. A rise in yields from low levels can signal an unwinding of risk aversion and better prospects for economic growth which is good for equities but too much of a rise could signal undue optimism in the economy and choke off the very same economic growth that was being anticipated.... it depends on how strong the economy is to be able to handle higher interest rates. Given the fragility of the economy right now, if bonds continue to spike from these levels I suspect it will choke off the rally like it did with other rallies.
I have been comparing this rally to that of March 2003 however since this week the comparison is starting to fade because we are seeing panic type buying which did not occur in March 2003. That rally was orderly all the way up. The March 2003 rally lasted for about 3 months. During the first 2 months of that rally, bond yields spiked, as was the case in prior rallies. There was a correction in mid May, which I'm sure got a lot of bears salivating given the high overbought and bullish sentiment readings at the time... but something different happened. Bond yields collapsed very sharply during that market correction and as the market started to rebound bonds yields continued their collapse and hit new multi decade lows. Thus with such low yields it gave equities the "all clear" signal to make another surge higher.
Therefore, if the market experiences a sharp correction and bond yields tank like how they did in mid May 2003 it could recharge the equity markets for another surge higher but if yields continue to rise or only marginally drop at best, it will serve as a headwind and a warning sign that the equity rally is doomed to fail badly.
No comments:
Post a Comment