By Michael A. Gayed
It is becoming increasingly clear that many are confused about what’s likely to happen next with U.S. markets.
The fact that L.A. Little's column advising readers to quit worrying about a 1987-style stock-market crash was as popular as it was Tuesday seems to be indicative of an underlying fear many have that a collapse could soon come, undoing stock gains for the year in a matter of weeks. The conclusion of that article? "If you can see it coming, then you need not blindly live in fear of it happening."
This, of course, is easier said than done.
It seems everyone is on the 1987-crash bandwagon now. Marc Faber of the Gloom, Boom and Doom Report sparked the debate, coincidentally after I’d brought up how similar 2013 has been to 1987 on CNBC the day before.
Interest rates are the heart, soul, and life of the free-enterprise system.
I contacted him after I saw his segment, and will be furthering the idea for his next report. I was planning on holding off on the discussion, but after seeing the responses to and social mood around Mr. Little's article, a different perspective in the here and now might be worth offering.
First, let's address precisely how crashes happen. Yes, they are largely unpredictable in exact timing. However, much like how driving in stormy weather increases the odds of a car accident, so too do certain market conditions and distortions, which can express themselves over time, pave a path toward crashes.
Those familiar with my Summer Crash of 2011 call know precisely what I am referring to as it relates to intermarket trend disconnects. Crashes tend to occur during deflationary pulses, prolonged internal distortions within and across asset classes, and sudden liquidity scares. Of those three characteristics, only two are observable through intermarket analysis, and even then the exact timing is never obvious.
Crashes do not have to be a bad thing, of course. For example, with the "next fat pitch" of emerging markets, a "crash" in the spread of the U.S. to BRICs in terms of relative performance seems likely, resulting in a potential significant re-sync of emerging-market stocks to developed-market euphoria. This is where our ATAC models used for managing our mutual fund and separate accounts are currently positioned for a trade.
But what happens after that synchronization? Can a 1987-style crash happen? The answer: It depends. The comparisons many use to 1987 do not provide the full picture. For the bulk of that year, stocks rose at the same time yields rose in the bond market. Prior to October, the 10-year rate was spiking. The stock market largely ignored the surge in rates as equities relative to bonds became massively out of step in terms of relative performance. The crash resolved the stock/bond relationship and outlier of relative behavior with yields then tumbling as stocks cratered.
Sound familiar? Yields have spiked this year (albeit from a much lower level), and U.S. stocks have completely ignored it on an absolute basis, just as in 1987. This is a disconnect which so few are focusing on, despite this being the key reason for why 2013 is reminiscent of the period prior to the Crash of 1987. So, yes, it is something to be worried about — maybe not for today or for tomorrow, but for some time in the near future if yields do not stabilize.
Are distortions building now? I think so. Financials are beginning to underperform despite a steepening yield curve, even though historically a steepening yield curve indicates bets on lending, growth and inflation are accelerating, which banks should directly benefit from. And what about the greatest source of reflation in housing?
Take a look below at the price ratio of the SPDR S&P Homebuilders ETF /zigman2/quotes/202739297/composite XHB +2.28% relative to the S&P 500 /zigman2/quotes/209901640/composite SPY -0.24% . As a reminder, a rising price ratio means the numerator/XHB is outperforming (up more/down less) the denominator/SPY. A falling ratio means underperformance. For a larger chart, click here .
Do you see what I see? Rising yields are causing a significant period of weakness in the greatest driver of economic activity right now, despite solid economic reports.
Broader U.S. beta is failing to see this as an issue presently, but the longer this persists, the more the odds increase of a big break in stocks that may not look exactly like 1987, but could surprise and be painful nonetheless. Just like 1987, spiking yields may serve as a deflationary shock that stocks readjust to in a very sharp way.
How does this fit into the fat pitch of emerging markets? I believe the first re-sync is emerging markets to U.S. stocks, and then all global stocks to a potential sudden realization that spiking yields are not indicative of a healthy economy but something potentially more negative than most realize. Speed matters, and if the relationship of stocks to bonds gets more extreme, conditions favor a meaningful break.
The bottom line here is that while one should be careful to not become paranoid about a significant collapse in the here and now, you should worry about the relationship of bonds to stocks. Intermarket behavior is not confirming the current leg of the Dow Jones Industrial Average rally.
Remember, while a downtrend or uptrend in a stock like Apple /zigman2/quotes/202934861/composite AAPL +0.07% might get loads of attention from the media, iPads do not impact the economy. A collapse in bond prices /zigman2/quotes/206026314/composite TLT +0.60% and spike in yields goes beyond technical analysis. It goes to the very heart, soul and life of the free-enterprise system.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.