Market Comment - August 17

(Marco Bonelli) Is a stock market rally entirely fed by money out of bonds a good thing?

Since July 26, the SPX advanced 5.78% and the NDX 8.59%. In these 16 trading days, 10yr bond yields rose from 1.39% to 1.82% yesterday while 30yr bond yields climbed from 2.46% to 2.93%! It's probably fair to say that a large part of the money, which was invested in bonds, found its way into the stock market, fueled by a more optimistic economic outlook but also diminished expectations for an imminent liquidity injection by the Fed (aka QE3).


Looking at bond yields over the last 30 years, the downtrend is very well known and even before QE successfully extended that trend, investors engaged in regular discussions when yields may have found a bottom. Looking at the developments of the last five years and particularly watching a possible double-bottom in the 30yr yields at 2.55%, the same question comes up again, followed by discussions how high yields may rise. The first major resistance may already come with the downtrends from 1987 that run at 2.65% in the 10yr and at 3.06% in the 30yr maturity. In the right environment, featured by little uncertainty and an expanding economy, yields could certainly move substantially higher from current depressed levels. But the current environment is different; this in combination with the series of macro events from the last five years certainly contributed to the drop in yields from the 4-5% level we have seen in 2007 - and QE1+2 and Operation Twist came on top of everything. It certainly takes a multi-page study to research the effects of certain events and the resulting money flows, nevertheless and in summary, it seems difficult to build a case for sharply higher bond yields that will feed a stock market rally over the next several quarters and the question whether we have seen the bottom in yields probably cannot get answered yet. Another question would be what will happen to stocks when certain events in the near to medium-term future knock yields down again.

In a more short-term note, the major indexes finally broke out of a tight and painful 7-day trading range, which brought the Dow Jones and SPX strikingly close to making a new yearly closing high. Trading volumes cooperates, market breadth didn't but with technology, basic materials, energy and industrials leading the move, the leader board appeared relatively strong. Not surprisingly, the 5th consecutive weaker than expected Philadelphia Fed Survey with its 6-month outlook dropping to levels from August last year got ignored (as were weaker than expected housing starts for June and July) as market participants slowly but surely embrace a more positive macro and micro-economic outlook (helped by recent data-points like a better Michigan Consumer Confidence - that plays well into the latest retail spending numbers - or a strong CAT Dealer-Survey for July). Since a lot of major indexes stage solid double-digit year-to-date gains, trade close to yearly highs and even appear to break out of these levels, performance pressure mounts and investors get forced into the market, no matter if they are convinced it's the right move or not. Optimism (sometimes also called "talking the books") follows closely after that, which makes the whole construction fragile for "unforeseen" events that don't fit into the bright outlook picture. Until then, market participants might be able to enjoy SPX prices at new 4-year highs and NDX prices at new 12-year highs!

Trade well.


(Marco Bonelli is the Managing Director of International for CL King & Associates in New York. The opinions expressed are his own.)