Bonds & equities: Expect a major shift

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This post is a guest contribution by Dian Chu*, market analyst, trader and author of the Economic Forecasts and Opinions blog.

The S&P has skyrocketed 58% since its bottom in early March, while the Dow is up 50% and the Nasdaq has surged 68% during that time. Meanwhile, bond prices led a rally as rates on the benchmark 10-year note have declined some 40 basis points since early August. This is good news for business: higher bond prices make it easier to refinance debt and stay in business.

Meanwhile, across the country, Main Street investors are weighing whether they should jump back into the market. However, the price correlation between equities and bonds of late has some argue that typically, if equities are trending higher, then bonds would head lower, and yield would be higher, due to concerns of higher inflation. This essentially describes “the Fed Model“, which is a theory of equity valuation popular among security analysts.

Now, the fact that bonds and equities in general are both firm seems to beg the question – which rally would end first – equities or bonds? This is an intriguing question which I will attempt to examine here.

A Split Personality Spells Uncertainty

Based on the Fed Model, bond yields should have an inverse relationship with the stock market in general. We can start by comparing the S&P 500 index (SPX) and the 10-year Treasury notes yield. As displayed in Fig. 1 by the two dotted trend lines, the correlation between stocks and bond yields is time-varying and, on average, negative over the last decade. Nevertheless, it appears, within the last two years, the negative correlation is more pronounced during the bear phase of the stock market from approximately May 2008 to March 2009 (Fig. 2 green circle).

25-sep-09-3

This simple observation is actually supported by economic research suggesting that the lower expected inflation and the real interest rate is likely to increase the negative correlation between stock prices and bond yields; and that the sharp inverse between stock prices and bond yields in the 1990s bull market can be partially attributed to the lower inflation risk during this period.

25-sep-09-4

The following are some plausible drivers of the current price co-movement between bonds and the equities market:

1. Fast money from Institutional and hedge funds is being allocated to both equities and bonds.

2. Flight from money markets to Treasuries due to the ultra-low interest rates in money markets and massive amounts of cash in the system as a result of the most synchronized global quantitative easing in history.

3. Depreciating US dollar is pushing up everything across the board from commodities, equities as well as bonds.

4. Market’s low expectation of future inflation signaled by the TIP spread of only about 1.75%. That is bond market’s 10-year expectation of inflation is now around 1.75%, lower than the inflationary expectations from 2003-2007 of around 2.5%. Low inflation expectation tends to push down bond yields and drive up the equities market.

5. Investors over-react to the “positive assertions” such as Federal Reserve Chairman Ben Bernanke statement that the recession is “likely over.”

Inflation & Interest Rate Expectations

There is often a multi-year lag between the cause (money-supply growth) and the effect (rising prices). So, even though we will probably be in the deflationary phase for the next 12 months or so, once economic growth starts kicking in, we’re bound to experience inflation.

What’s more, the current low inflation expectation of 1.75% is signaling the stock market is most likely mispriced and overvalued right now. Wider recognition of the inflation problem will eventually emerge. Inflation plus a recovery means sooner or later the Fed is going to have to start raising rates.

Higher interest rates and inflation expectations, coupled with the overvaluation in the equity markets could lead to a bear phase and the dreaded W-shape double dip economic scenario. This would mean a major decline in both the stock market and Treasury bond prices (a major rise in bond yields) and borrowing costs for companies will increase exponentially, thus further hindering future growth prospects in the economy.

Expect A Major Correction

The stock market is overvalued and due for a substantial pullback based on any measure of future earnings. Ultimately, bond yields are unsustainable long term, and must rise significantly to pay holders of US Debt for the risk of holding Treasuries against the backdrop of inflated government balance sheets, larger budget deficits, and associated interest expenses on the national debt.

It’s ironic that the takeaway from all this is that both the equities & bond market are mispriced and headed in the opposite direction over the next 24 months. Equities are way overpriced and headed for a major correction (Dow 8,000 level) is a more rational valuation even taking into account improved earnings in 2011.

Expect the 10-year Treasury yield to rise above the 5.25 level in 2011. Increased borrowing costs, a jobless recovery, the collapse of commercial real estate will provide quite a headwind for anyone thinking of making a killing in equities over the next 2 years from the long side.

Bottom Line – Portfolio Repositioning

Start investing in alternative investments like residential real estate, which is where most of the smart money will seek outsized returns, as slowly but surely the favorable long-term demographics start to kick in, as the population increases, excess housing inventory evaporates completely providing for a housing squeeze in 2011. Real estate is actually the best inflation hedge of all, as they call it “Real” for a reason, unlike the US currency.

Source: Dian Chu, Economic Forecasts & Opinions, September 24, 2009.

* Dian Chu is a market analyst, trader and financial writer for Zero Hedge, Seeking Alpha and Daily Markets. Her articles are also syndicated to Reuters, USA Today and BusinessWeek. Professional credentials include M.B.A., C.P.M. and Chartered Economist with extensive professional experience in market segment forecasting and strategies. She is currently working in the US in the energy sector.

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2 comments to Bonds & equities: Expect a major shift

  • JJ

    Good one post, thanks.

  • Kurt Schoeneman

    Real estate? Not if folks keep defaulting on debt. Reduces M3. I’d be careful looking around for inflation hedges, because if the omnipotent Fed and Treasury turn out to be smaller than the economy, they will lose. Kind of a dilemna. Watch the baby boomers here in America. See what they do. Their risk is high.

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