On the Cyclical Nature of Financial Markets

Most investors believe that markets behave cyclically, like an ocean tide that ebbs and flows. Bull markets give way to bear markets; booms turn into busts; low interest rates yield to high interest rates. And it’s true, markets are cyclical…but not like ocean tides.

Financial markets are cyclical…like an Ouroboros – the mythological snake that devours its own tail. Economic trends are forever in the process of devouring parts of the financial markets. Recessions consume stocks; recoveries consume bonds.

In the best of circumstances the stock market steers clear of recession for long enough to heal…and to resume growing again. But that’s not guaranteed. Often, the stock market drags its mangled body away from the ravages of recession and, eventually, manages to recover its former health…just in time for the next recessionary downturn.

Bonds endure a similarly precarious existence. They tend to flourish during recessions and to struggle during recoveries…especially during the kinds of recoveries that also produce inflation. Thus, for long sweeps of time the bond market inflicts more pain than a dungeon master from the Middle Ages.

In other words, as your editors here at The Daily Reckoning never tire of pointing out, the financial markets are primal…not domesticated. No matter how docile they may appear at times, the financial markets will always be more cheetah than Chihuahua; more Great White than goldfish.

We do not present these metaphors to terrify investors, merely to frighten them. A vigilant investor is often a successful one.

But what does it mean to be vigilant…especially in today’s very baffling macro-economic environment? Should the vigilant investor be buying stocks because the economy seems to be recovering? Or buying bonds because the economy’s bounce will quickly fade?

As usual, these questions produce no easy answers. The US stock market, in general, seems pricey and dangerous. The US bond market, in general, seems even pricier and even more dangerous.

Therefore, if forced to choose, your editor would be a much more eager seller of bonds than stocks. Although, truth be told, he’d be a seller of both, and a buyer of selective commodities like uranium, gold and natural gas. But you’ve read all that before. Today our discussion is about the bond market, and the risks that threaten the holders of long-term Treasury securities.

The largest single threat to a bondholder is the risk that inflation will re-emerge with surprising strength. So far, inflation remains relatively quiescent, based on the government’s suspect data. But even the government’s data reveal that signs of inflation are emerging. As we observed in Tuesday’s edition of The Daily Reckoning, the Consumer Price Index (CPI) calculation that excludes residential rents shows that inflation has been rising at a 3% clip since the end of 2007, despite the fact that the economy has been recessionary throughout most of this period.

The residential rent calculation contributes about 30% of the total CPI number…and rents are certainly deflating. On the other hand, the other 70% of the CPI that measures the cost of the goods and service is telling us that inflation is far from dead.

Urban CPI Index

A second potential menace that could threaten the Treasury market is declining demand from “Foreign Official Holders.” This important source of demand for Treasuries includes foreign central banks, ministries of finance, sovereign wealth funds, etc.

Buying by foreign official holders soared from $1.7 trillion worth of Treasuries in mid-2008 to about $2.7 trillion by mid-2009. Foreign official holdings have remained at that lofty level ever since. Unfortunately, the US government’s borrowing has not stood still. It has been soaring, which means that foreign official holdings – as a percentage of total Treasury securities outstanding – has been dropping sharply during the last six months. Not surprisingly, 10-year bond yields have jumped during the same time frame. “Bonds have seen their best days,” says Bill Gross, manager of the world’s biggest bond fund at Pacific Investment Management Co.

10-Year Treasury Securities

As the nearby chart illustrates very clearly, an inverse correlation exists between the trend of bond yields and the trend of foreign official holdings of Treasury securities. From the middle of 2006 until the fall of 2008 foreign official holdings increased steadily from about 31% of all of Treasury securities outstanding to more than 40%. Over that timeframe, the 10-year Treasury yield dropped from more than 5% to less than 3%.

The inverse correlation between foreign official holdings and long-term treasury bond yields is not precise, but it is evident…and intuitive. Obviously, foreign official holders like central banks are not the only buyers of Treasury securities, but they may be the most important marginal buyers. Therefore, to the extent that their appetite for Treasury securities wanes, bond yields are very likely to rise.

Watch this space…very carefully…dear vigilant investor.

Lastly, for those readers who were concerned that your California editor might make it through an entire edition of The Daily Reckoning without offering a few unkind words about the stock market, fear not…

One of our favorite options gurus, Jay Shartsis, of R.F. Lafferty in New York, points out that bullish investment sentiment has swung to an extremely extreme, extreme…which is a very bearish indicator for the stock market.

He observes:

“The 10 day CBOE equity put/call ratio is at the lowest level (most call buying) in four years. The ‘speculation index’ – that is OTC volume compared to NYSE is at the highest (most speculation) in 15 years. The Consensus survey shows 70% bulls. Investors Intelligence shows bears at less than 20%. This is one lopsided bull boat. Something’s got to give here.”

So to recap: Sell bonds, based on a long-term view; sell stocks, based on a short-term view; buy gold, based on a combination of befuddlement and caution.

We know it’s only April, but maybe it’s not too early to “Sell in May and Go Away.”

Eric Fry
for The Daily Reckoning