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The Great Rotation? The Market Is a Bit More Complicated Than That


Now is not the time to dumb down the interplay between stocks and bonds.

Risk-free assets are risky.

The market events on Friday, January 25, were a microcosm of the post crisis reflexive reality. While two egomaniacs were having a cat fight on CNBC about a meaningless company, the Fannie Mae current coupon 30-year MBS price was trading at par, yielding 2.50%. That is slightly more significant in a QE world where the Fed has pledged open-ended bond market purchases to keep a lid on interest rates only to see them rise in their face.

Fannie Mae MBS CC v 10YR UST

Friday's price action in the bond market was a perfect example of how the reflexive nature of negative convexity can drive price action. As I stated in Explaining Irrational Behavior: It's a Reflexive Process:
As prepays slow and MBS extends so too does the need to hedge prepay risk thus turning MBS hedging Treasury buyers into sellers. The more rates rise, the more these low coupon MBS will extend and the more Treasuries they will sell. This is negative convexity in the other direction.

That seemed to be what was happening on Friday as the selling in USTs originated overnight due to the news out of Europe. Initially MBS held their ground but attempted relief rallies in USTs could not find any legs and MBS succumbed to the pressure as the current coupon took out the par handle. The reflexive relationship between USTs and MBS looked to be kicking in as selling begat more selling.

In my view this was a significant market development because of where the long end of the curve sits from a technical perspective. Recall in my 2008 Bond Market Prognostication:
I think 143-00 is a huge number. It was a climax top in 2008. It was made support in 2011 and 2012, and it's very close to two standard deviations in the rising channel. If violated to the downside, a bond market top could be in place, but don't expect it to go quietly; it will likely put up a tough fight.

US Bond Futures Contract Weekly

Fear is a better reason to buy than fundamentals.

This week we have a busy calendar of market-moving events. Beginning with Wednesday's Q4 GDP report and FOMC meeting. Then on Thursday we get Chicago PMI, and on Friday the January employment report followed by ISM manufacturing. If the market needs to test 143-00, next week could be a great opportunity. You can see on the chart there is enormous support in the area between 143-00 and the rising channel. The fate of the bull market will bet settled at these crossroads. Expect this area to get vibrated and the reflexivity of the MBS market to play a key role in how this gets reconciled.

Of course the stock market is playing a key role in how bond market price action is perceived. It's not negative convexity pushing yields higher, it's investors selling bonds to buy stocks. This is not a time to dumb down the interplay between stocks and bonds in as simple terms of a Great Rotation. It's not that simple.

S&P 500 Book Value

Stocks are cheap and expensive at the same time.

Investors buying stocks today are buying at one of the most expensive prices in a decade but also at one of cheapest valuations. You can see on the chart that despite the consensus that QE is pushing up stock prices, the multiple to book value (shareholder equity) is near the lowest of the cycle. If QE was responsible for rising stock prices you would think this would be reflected in a higher valuation, but clearly that has not been the case. In fact throughout the entire era of easy money designed to reflate asset prices the multiple paid for the assets has steadily declined.

The book value has simply risen along with nominal GDP and both currently are at historic highs. The price of the S&P 500 has risen simply on the back of a growing book value. For stocks to see a meaningful correction from here it will have to be in a contracting multiple. This can happen in times of rising inflation and/or rising interest rates. The 1982 low in the S&P coincided with a 1x price to book value ratio. You can see if the market experiences a bear market cycle that leads to multiple contraction, where that multiple settles could produce a wide variety of outcomes, with ranges from as little as a 10% correction to a 50% massacre .

Common sense says not to trust your common sense.

The biggest risk to higher stock prices is stocks going higher, and the biggest risk to rising bond yields is bond yields rising. The bull case in stocks isn't predicated on earnings growth, it's a function of relative valuation due to negative interest rates. If stocks want to rally to new highs and prick the bond bubble, that supposed relative value goes away. The bear case in bonds isn't predicated on inflation, it's based on the rally in risk. If bond yields rise it will be in the back of the curve, leading to a vicious bear steepening move that will likely put severe pressure on credit and equity risk premiums.

If you look at it on the surface and assume a few trillion parked in bonds could suddenly come roaring into stocks, you would obviously not want to miss that train. However the market is a bit more complicated than that. I believe Chris Cole is correct. I believe the power of reflexivity governs the market. As Cole says, the market is a mirror unto itself. It is the impossible object.

Twitter: @exantefactor
No positions in stocks mentioned.
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