Stock-bond divergence widens

Amid all the mathematical models and Marxist malarkey about the 'end of capitalism' - the only operable and useful teacher in this environ is the history of market behaviour.

And the market, like a cryptically silent Zen master, lets the perspicacious student infer as per her wisdom and investing time-horizon. As a result, today we have a peculiar phen-menon where the equity markets and bond markets have dramatically different inferences on the future.

The equity markets on Friday, after a seven-month rally returned 61 per cent including dividends, as Bloomberg reports. The underlying assumption behind this rally is that the state of the economy is such that aggregate demand is likely to increase, going forward. Also, the sectors that have rallied dramatically - information technology, industrials, materials and discretionary consumer - point to three critical phenomena.

Alongside massive governmental fiscal and monetary expansion the assumption is that there is to be global rise in infrastructure expenditure. Second, there will be a greater push towards productivity - and thus increased investment in automation of processes.

Third is a more structural and secular belief that the worst is over. As a result, as John Dorfman of Thunderstorm Capital reports, the early parts of the rally typically skyrocket, making around 40 per cent to 60 per cent of the gains. In essence, economic growth and recovery are on the cards - if the equity markets are to be believed. In the bond market, however, the plot lines indicate a deflationary expectation. The 10-year treasury yield now stands around 3.35 per cent, which is around 55 basis points less than July 10.

The demand for the long-term bonds have begun to increase, leading to a price rise. The real extent of the decline in the yields very clearly points to a bond market that expects deflation. Bill Gross, the "bond king", along with Mohammad Al Erian, has been talking about a "new normal". This refers to their favourite theme that "deleveraging, deglobalisation and reregulation" are in the works.

Resultantly, the industrial economies will grow much slower, government intervention will increasingly play active part in countercyclical policy measures – and consumer spending will slowly reduce. In essence, aggregate demand will decrease, and the AD-curve (as undergraduate economics textbooks tell us) has exogenously shifted down!

 
In both cases, there are historical precedents that progress and retrogress their respective arguments. For eg., it is quite clear that equity markets make bad predictors of economic future. Over the past 20 years, there have been four instances when equity and fixed income markets diverged – in 1994, 1998 and 2000. In each of these cases, the equity markets had rallied only to be followed by what the bond markets had implicitly predicted.

In contrast, over the past 100 years, there have been eleven spectacular retractions in the equity markets – all of which were followed by rallies that lasted at least a year. And in this sense the equity markets are consistent. What however matters is the 2-5 year frame of reference. And here, typically the bond markets have been spot on. Be it inversion of the yield curves at the height of the boom; or in the present case, a slow flattening of the curves at the long end.

Going by the filings of 13-f documents filed at the SEC by John Paulson, who made over 600% (or 15bn USD) last year, is any indication – he's been investing heavily into gold (an inflation bet), financial sector (a recovery bet) and healthcare (a structural bet). However, amidst increasing preponderance of evidence that the bond markets are superior predictor of the future – the elephant in the room is the extent of political intervention. Is re-regulation really a possibility? Is de-globalization – whatever Mr. Gross means by that – a reality awaiting us? Is the New Labor & New Democrats vision under Tony Blair and Bill Clinton really dead? Depending on how one assesses these questions lies the future of government spending and implicit.

In essence, depending on ones horizon of investment – both markets have ample signals to reveal its expectations. And from expectations emerge realities. As Faulkner wrote, the past is not even the past. Remembering that is key to the future, and to making money in the markets.

 - The columnist works for a major European investment bank in New York City.