Which Market is Correct?
May 20, 2013
Chad Karnes, Chief Market Strategist
The four major asset markets are tied together through several key relationships. Stocks and bonds are typically inversely related. When bond prices rise stock prices usually fall as investors shift money to bonds instead of stocks.
When commodities rise, equities typically do the same. Basically, a positive macro environment increases demand for both commodities and equities.
Finally, the U.S. dollar should be inversely related to stocks and commodities. A falling U.S. dollar implies an inflationary environment, which helps both commodities and equities. A rising U.S. dollar implies the opposite, a disinflationary or deflationary environment.
The rally since 2009 is missing most of these typical relationships.
Let’s do a checklist of what usually is occurring in a rising equity markets (NYSEARCA:VTI) environment as has occurred since 2009.
Bond prices should be down? They aren’t.
The dollar’s value (NYSEARCA:UUP) should be declining (as it did during the equity boom years of 1985-2007). It is actually up in value since 2008.
Commodity prices should also be up, but they have been declining rather sharply since 2011.
This is not your typical confirming market behavior.
For five years bonds, the dollar, and stocks have all risen in price when bonds and the dollar should have done the opposite of equities.
For two years commodities such as copper, silver, and energy prices have shown weakness suggesting a global slowdown, but stocks continue their rise, not confirming such a slowdown.
The disconnects keep adding up, and it is difficult to know which markets to trust.
Do equities know something the other markets don’t? Will traditional macro relationships return?
Trust the Bond Market?
Bond markets around the world suggest a “lack of inflation” environment in which investors demand safety, expect slow growth, cut back on their spending, and keep bond yields low indefinitely (the 30 year hovers around 3% - this alone implies growth expectations are to be subdued for 30+ years).
Demographics also certainly support such an environment as the older the baby boomers get, typically the safer the assets desired.
As an example, Japan’s 10 year bond yield first reached the sub-1% level in the late 1990’s. It remains at .86% today (its equity markets also saw multiple 50% declines during that time of low rates).
Germany’s 10 year bond yield has also slowly declined to below 2%, down from 7% in the mid 1990’s. Other European and developed markets are dealing with similar declining bond yields.
This is not inflationary and implies equity markets should also be expecting slower future growth.
The below chart provides the history of bond yields in some of the major developed economies of the world. There is an obvious trend.
The fundamentalists are having a tough time justifying what’s going on as the “Great Fake Rotation” in January taught us. For years “experts” have called for the impending bond market top, but it has yet to surface. If Japan (shown in the chart above) is an example, then it will be awhile before it ever does.
We were actually able to take advantage of falling yields on 2/15 in our ETF Profit Strategy Newsletter where we advised bonds were in a “pullback to be bought” and TLT was trading for $116.18. We recommended taking profits on the iShares 20+ year Treasury Bond Fund (NYSEARCA:TLT) when it rose to $122.82 on 4/5.
Bonds around the world continue to be bought and continue to not confirm the equities market rally.
What about Commodities?
Commodities peaked in price in 2008, and a number of them did manage new highs above those levels, suggesting an improving macro environment. Precious metals, livestock, corn, soybeans, and lumber all managed to make new highs.
However, taken as a whole, commodities are still down in price since 2008, peaking at a lower level in 2011, and falling swiftly since.
Copper, which is considered the barometer of the world’s fundamentals has fallen 30% since its highs in 2011. Coffee prices (NYSEARCA:JO) are down almost 50% in the last year alone. Most commodity prices are down since 2011. This too suggests the world’s economic condition is not as rosy as the equity markets imply.
The most recent example of a commodity not confirming the equity markets is lumber, which has fallen 20% the last two months.
Homebuilding stocks (NYSEARCA:XHB) should be on the lookout as I suggested in the article I published on 5/15 titled “Timber! Watch Out for Falling Lumber Prices."
Commodities are showing signs of a weak macro environment, not a strong one as equities suggest.
Caution on Equities
So are all the major asset markets except equities wrong? Is this a new paradigm? Do the equities markets know something the rest of the world doesn’t? I think you know where I am heading.
To me the table below sums up much of the reason for the equity markets continued rally. The equity markets are up, but not because of improving fundamentals.
Stock prices are rising because of expanding multiples, not because of a fundamentally better earnings backdrop.
Multiples expanded 35x faster than earnings over the last year ended March 31, 2013 and 33x faster in 2012. This means stocks are going up because people are chasing price, not because equity valuations have gotten any better (in reality they have gotten a lot worse).
In December 2012 and again in the first quarter 2013, multiples expanded over 30x as much as earnings grew (outlined in the table above). P/E ratios are up 15% over prior year, but earnings grew less than 1%. At the 2012 year end, multiples expanded 13% over the previous year, and again operating earnings showed flat growth.
With June 2012’s P/E at only 13.8, the multiple expansion ratio will likely only get worse, unless earnings really start to pick up (not expected), or the market starts to tank.
Previous to today Dec 1998 was one other time this phenomena occurred (and we all know what followed shortly after). Besides that quarter, the only other example of another time multiples expanded this much without earnings confirmation was from 1989, which preceded a market pullback of 20% by Fall1990.
The equities market (NYSEARCA:DIA) has likely gotten ahead of itself and is the outlier of the asset classes.
This of course doesn’t mean you should sell out of all your stocks today. The previous example from 1998 saw prices continue their rise another year, before the multiple bubble burst and prices fell back to reality. In 1989 the markets rallied another few months before their peak finally occurred.
A better alternative is to wait for key price levels to warn of a market correcting this over expansion. Currently we are keeping our eye on two key levels to warn us of a market that is ready to finally correct its overzealousness.
The ETF Profit Strategy Newsletter uses common sense combined with fundamental, technical, and sentiment analysis to help stay ahead of the market’s trends.
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