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The Only Three Things Stock Investors Need to Focus On Right Now

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Yields on 10-Year Treasuries have risen more than 30 basis points in a little more than a week. So how is it that this is good for stocks? After all, the mainstream media is horrified that not only have interest rates moved steadily higher in recent weeks, since QE2 was announced interest rates on the 10-Year have soared from less than 2.5% to more than 3.6%. Of course, what is going unnoticed and unreported is that yields on junk bonds have actually fallen by almost 20 basis points over the same period.

What is going on here? One word: demand. Demand for yield as portfolio managers look to move out of Treasuries and add risk to their portfolios. Playing catch-up is hard. And it's likely we haven't even entered the most intense part of this credit boom. (More on how this ends in a moment.)

Meanwhile, this credit boom won't stop stock traders from zeroing in on Treasury yields as a key for short-term decisions, but here is the key: investors should fade the traders. Ultimately, it is not Treasury yields that will benefit stocks, it is corporate debt issuance, which most stock traders know nothing about, and at this point in the cycle it's not even about the price at which bond investors lend, but their inclination to lend.

One of the things I wanted to make clear in "The Time for Bearishness Has Passed' in June 2009, was that investors must put aside their Ultimate Scenarios and stop predicting end-game outcomes. There are games designed for billionaires and games designed for the rest of us; Ultimate Scenarios are for billionaires. You are not a billionaire. Stop trying to piece together macro scenarios as if you are one. There are only three things you need to focus on right now:

1) The Credit Boom
2) How corporate debt issuance impacts balance sheets (it puts money into them)
3) What corporations do with that money (they buyback stock, increase dividends and buyout other companies)

Yes, this credit cycle and credit boom will end, and for the financial sector the end may even be worse than the last credit bust, but that end is not near. Again, we aren't even into the most intense part of this credit boom. When should you worry? Start to worry when we go at least three consecutive months where a journalist does not write a column bemoaning how the return of some arcane credit market practice means we're doomed to a new systemic collapse; i.e. "covenant-lite buyout loans returning to the U.S. market" etc. etc. What you are observing in this type of reporting is anchoring based on the most recent available data. In a couple of years, this type of reporting will get boring and as the credit boom continues and we move farther away from the most recent credit bust, reporters will begin to dig up reasons for why it will never end. Then you can worry.

Three charts help illustrate what is really happening behind the scenes in credit markets.

The first is the average of the five-year CDS for select Banks: For this I chose Bank of America (BAC), Wells Fargo (WFC), Citigroup (C), JP Morgan Chase (JPM), Morgan Stanley (MS), Goldman Sachs (GS) and Capital One (COF).

The next is the average of teh five-year CDS for select Insurers: For this I chose AIG (AIG), Hartford Financial (HIG), Prudential (PRU), Allstate (ALL), Berkshire Hathaway (BRK) and Chubb (CB).

AIG is actually contemplating a new debt sale after issuing $2 billion in bonds on Dec. 1. The mere fact the company can even access debt markets is testament to how willing the bond market is to loan money. And so those two charts show how CDS have stabilized for the financial sector post-crisis, but what about other areas of the economy? Well, let's pick an extraordinarily capital-intensive sector that is highly dependent on energy costs and is having difficulty both managing cost structure and maintaining pricing power in a weak economy... an industry such as, say, Airlines. Here are AMR (AMR), JetBlue (JBLU), Delta (DAL), UAL (UAL) and Southwest (LUV).

The point of this chart isn't to say these are great companies in a great sector, but to point out that even with all of the problems these companies face the improvement in their CDS is incredible.

So, again, for equity investors, the main thrust of financial media coverage is that the economy is terrible, unemployment is high, interest rates (for Treasuries) are spiking and all of this together will push the stock market lower, which we all know is only where it is because the Federal Reserve and a handful of guys sitting in offices in New York and D.C. are buying stock index futures to support the market.

Meanwhile, on a technical basis, DeMark price exhaustion techniques suggest we may finally get the much-anticipated correction beginning next week. Exhaustion signals are likely to align for the S&P 500 and select European indices on both a DAILY and WEEKLY basis next week. Stock traders will win this battle and the financial media will claim victory for pointing out all the reasons why markets are selling off (take your pick: Treasury yields, inflation concerns, end of QE program, beginning of next round of QE, indecision about QE, inflation, deflation and stagflation, and so on...), but stock market investors who focus on companies diverging from the broad indexes and who are positioned to engage in (or benefit from) shareholder enhancement activities like buybacks and buyouts, will win the war.
POSITION:  No positions in stocks mentioned.