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Bond Yield Breakout Foreshadows Economic Acceleration?

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    May 24, 2013

    Perhaps THE biggest event so far this week was the breakout in 10-Yr UST yields today north of 2%. As shown below, the 10-Yr UST broke the bearish trend that has been in place since 2011. With the current move north of 2% the next stopping point is likely to be 2.4%, which marked the late 2010 low and resistance levels for 2011 and 2012. A jump up to 2.4% may not seem like much but a move to that level from the recent April low of 1.61% is nearly a 50% rise!

    10-yr ust yield
    Source: Bloomberg

    The reason a breakout in yields is significant is that it likely portends either a pick up in the economy and/or rising inflation expectations. Historically, when rates begin an upward ascent the S&P 500 has usually logged significant gains as seen by the shaded green boxes below.

    10-yr spx
    Source: Bloomberg

    As I’ve tried to highlight on several occasions, a weak Q2 was to be expected (Expecting a Weak Q2, But Likely a Buying Opportunity) but we should see acceleration in growth to close out the rest of the year. Please see the following reports for reasons why:

    There are many market skeptics out there attempting to argue why the market is wrong and have been citing recent economic releases such as the Chicago Fed National Activity Index, Philadelphia Fed, and Empire Manufacturing Surveys as evidence of economic decline and thus, it is assumed, of a stock market ready to correct. One of the main reasons I feel skeptics haven’t been correct so far in forecasting the phenomenal strength of the market in the face of subpar economic data is that the stock market is a forward-looking mechanism and gives little weight to data reflecting the state of the economy one or two months prior.

    This is a common mistake that many investors and analysts are guilty of, which is why it is extremely important—that is, for being on the right side of the market—to track leadingeconomic indicators, telling you what the economy will look like months in the future. When we do this currently, the market’s rally begins to make sense. Granted, while many regional Fed manufacturing surveys have come in on the downside, four of the five surveys are expected to improve continually to close out 2013.

    As explained in many articles in the past, investment strategist Francois Trahan has shown that, with zero-bound interest rates, inflation cycles are the key driver of business cycles. As such, taking current inflation trends and pushing them out six months provides a prediction of what economic activity trends will be like half a year out.

    Shown below are five regional Fed manufacturing surveys where we see that the New York Empire Survey is the only regional Fed survey that will continue to be weak through most of 2013, while the other four surveys are expected to continue to improve in the second half of the year. It is likely this reacceleration in economic growth that the stock market is discounting as well as the bond market with the breakout in 10-yr UST yields.

    regional isms
    Source: Bloomberg

    There are many bears out there that simply cannot fathom why the market is up to such an extent but they better get on board as this is likely to be an above-average year for the stock market. The excellent Bespoke Investment Group, which puts out great work, took a look at the most number of positive days in the first 100 trading days of the year. This Friday will be the 100th trading day of the year and so far the S&P 500 has been up 61 days and down 36, and is on track to being tied for fifth place in terms of most positive up days. Bespoke took a look at the number of times the S&P 500 was up at least 60 days in the first 100 days of the year and found this occurred only eight times since 1928. Of those eight year, the S&P 500 averaged a 9.1% return over the rest of the year and was positive seven out of those eight times for an 88% hit rate. Interestingly, the only negative year showed a loss of a mere 0.43%, which occurred in 1975. So based on history, the bears should be very uncomfortable about their position.

    positive days
    Source: Bespoke Investment Group

    The bears are simply having a hard time being bullish on the stock market, but they have to be bullish on something with many being bullish on cash as an asset class. What they need to remember is that financial capital always seeks out the best return and investing is sometimes more about choosing between the lesser of two evils. A simple demonstration of this is to look at the ten year return differential between stocks and bonds which is shown below. At the March 2009 lows we reached the worst relative return by stocks over bonds since the Great Depression, which ended up back then being a very attractive time to overweight stocks over bonds. Even after a 100%+ rally in stocks they still are depressed relative to bonds on a 10-year relative return basis and suggests that the stock market is still the place to be.

    relative returns
    Source: Bloomberg

    What may come as a surprise to many is that the S&P 500’s dividend yield relative to the 10-Yr UST yield is near the highest level in nearly a half century as shown below. In fact, the spread between the two is not that far off from the level seen at the March 2009 lows!

    relative valuations
    Source: Bloomberg

    Any way you slice it, stocks offer a superior return relative to bonds and the bears should not lose sight of this fact. Additionally, the bears should spend more time focusing on leading economic indicators rather than coincident models as the market cares about what has yet to happen over what has already occurred. Based on leading economic indicators, we are likely to see an accelerating economy to close out the year, a development the UST market is likely beginning to discount with the breakout in 10-Yr UST yields.

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    About The Author – Chris Puplava, Financial Sense Online

    Chris graduated magna cum laude with a B.S. in Biochemistry from California Polytechnic State University, San Luis Obispo. He joined PFS Group in 2005 and is currently pursuing the designation of Chartered Financial Analyst. His professional designations include FINRA Series 7 and Series 66 Uniform Combined State Law Exam. He manages PFS Group’s Precious Metals Managed Account, Energy Managed Account, and Aggressive Growth Managed Account. Chris also contributes articles and Market Observations to Financial Sense and co-authors In the Know—a weekly communication for Jim Puplava’s clients only—with other members of the trading staff. Chris enjoys the outdoors.