A Tale of Two Markets

By ,   August 18, 2014

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The movements of financial markets can be difficult to rationalize especially given the ever-increasing complexity of world markets.  The media feels a critical need to assign every market move to a specific “cause” even though there is no possible way to prove that was indeed the cause.  Removing day-to-day fluctuations, even analyzing a trend can be challenging.  The problem arises when real markets deviate from what “should be” happening.  Business cycles, government monetary and fiscal policy, valuations, etc. – all have some influence into what “should be” happening based on economic and behavioral finance theories.  

We currently see that deviation in today’s stock and bond markets.  Each market seems to be communicating very different consensus views.  The stock market, on one hand, maintains a relentless up trend where we have not seen a pullback of more than 10% in over 500 days.  Such a move appears to be justified as we have seen consistent job creation of +200k per month, manufacturing and services data solidly in expansion territory, and little sign of inflation.  

The bond market, on the other hand, has confounded many experts this year as most called for higher rates (and thus lower bond prices).  Yet, rates have consistently fallen this year.  It has been speculated that the rally in bonds could be due to pension portfolio rebalancing, sovereign yield pickup trades, or even “flight to safety” risks given geopolitical tensions.  Here, unlike the stock market, is where we feel we have a deviation from what should be happening.  Generally, markets are forward looking; and as the Fed has started to remove stimulus, it was expected rates would begin to trend up.  

It is like shaking up a soda can, then trying to pop the tab.  With enough shaking, the pressure builds and eventually explodes as it releases.  In market terms, I’m reminded of the Internet Bubble back in the late 1990s.  At that time, stock fundamentals became so disconnected from the price, that eventually it led to a crash in the market until prices normalized again.  

While I do not think we are heading for a “crash” in the bond market, I do think we are seeing a disconnect due to short term pressures, such as geopolitical events.  The pressure building could lead to a faster move than the Fed is intending, potentially triggering an end to this nice long period of low volatility.