One of the more unusual trends that has developed since early July and one worth monitoring over the coming weeks.

Regards - VHF

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One of These is Lying… Guess Which One?

Graham Summers

August 5, 2010

In today’s highly correlated, computer dominated market, virtually every asset class moves in lock stop with one another to some degree or another. One of the stronger correlations of the last few months has been that of S&P 500 and the 10-Year Treasury yield.

As you can see, since the April top, the 10-Year Treasury yield has moved in close correlation to the S&P 500: as the stock market fell, investors piled into the perceived safety of Treasuries pushing prices higher and yields lower.

However, something very unusual began in early July: the stock market began a sharp rebound, which should have been accompanied by yields rising/ Treasury prices falling as investors perceived that “all’s clear” in the markets.

Instead, what happened was that stocks rallied and Treasury yields continued to fall even further:

Put another way Treasuries (which typically act as a proxy for fear as investors pile into them whenever they’re spooked) and stocks (which are a proxy for risk appetite as investors move into them whenever they think the coast is clear) are rallying together.

In a sense, the financial markets are telling investors that it’s both dangerous AND safe… at the same time.

One of these is lying.

Of the two, it’s likely stocks.

The bond market is twice as large as the stock market, which makes it a lot more difficult to manipulate than the latter. Moreover, bond investors are generally viewed as more sophisticated or “smarter” than stock investors.

Indeed, if you go back and look how the two assets performed during Round One of the Financial Crisis, you’ll note that Treasuries actually began rallying hard back in July 2007 (signaling all is not well) while stocks actually put in a final rally to a new high in October 2007, a full three months later.

What followed, of course, was a stock market collapse culminating in the Crash of 2008. Treasuries were proven right.

In light of this, it’s important to note that this recent rally in 10-Treasuries has actually put them BACK UP to levels not seen since the absolute NADIR of Round One of the Financial Crisis: 4Q09 and 1Q09. Put another way, investors today are as spooked as they were in December 2008!

In plain terms, the above chart screams “RED ALERT.” It’s as though the bond market doesn’t trust the stock market rally in the slightest. Which certainly doesn’t bode well for stocks, which are on an absolute tear on next to no volume:

What you see here is a greater than 10% melt-up in one month’s time on ever dwindling volume. This is precisely the market action we saw for most of 2009. Whether it’s the market discounting QE2 or simply doing a blow off top, this is

NOT the beginning of a new bull market. It is a last hurrah, the final dance before the Titanic crashes into the iceberg.

As was the case before the 2008 Crash, most people will not see this Collapse coming. They will think everything’s fine, right up until it isn’t. They’ll think the stock market rally is indicative of something other than Wall Street killing the shorts on next to no volume. They will buy into it and believe that the mess from April and May is over.

This will end in disaster just as it did in 2000 and 2008. Once again we have the same folks proclaiming a new bull market is underway. Once again we have the world believing that the Fed can fix everything and that funny money can prop the whole financial system up. And once again, we have people getting bullish despite the fact that a full-scale debt Crisis is already beginning in our backyard: state and local governments are literally on the edge of the abyss in terms of their finances.

Which probably explains why investors are fleeing into the perceived security of Treasuries even as stocks continue to melt upwards. Treasuries may not offer much return ON capital given the current yields, but with the Financial Crisis ready to explode anew, this time in the US, the mere fact Treasuries offer a definite return OF capital (the US can always print money to pay investors back) is relatively attractive.