Trader’s Narrative

Late last week we got the latest figures from the Reuters/University of Michigan survey. Consumer sentiment continues to recover with the preliminary June 2009 number at 69% - compared to 68.7% for May 2009. The consensus of economists was for a larger recovery but there is no doubt that US consumer sentiment is slowly recovering from the drubbing it got a few months back. Things were so extreme that we hadn’t seen such low consumer sentiment since 1980!

But there was another data point that got my attention from the Reuters/University of Michigan survey. There was an increase in the number of people expecting an increase in interest rates from 36% in May to 53% in June.

With those that expecting the opposite shrinking from 19% last month to just 10% now. This differential is the largest since August 2007 (red arrows in chart):

Keep in mind that bond yields and bond prices move inversely. So a fall in yield would be accompanied by higher bond prices.

As you can see in the chart, the red arrow doesn’t coincide exactly with the 2007 summer peak in yields but then again, if we go back we find that the chart consistently trends downwards. In fact we could look back 10, 15, 25 years and more and still find that yields in a downtrend. Of course within this macro-trend there have been some very sharp counter rallies - of which the early 2009 rally stands out.

According to seasonality, we are coming into the time of the year when it has historically been a good time to be long bonds:

But seasonality isn’t everything. It is only one piece of the puzzle and even at that, it is anaverage of many years, smoothing out the year to year volatilities.

I disagree with it this year and don’t think right now is a good time to be long bonds. There are several reasons. For one, the sentiment regarding bonds isn’t gloomy enough. The AAII bond allocation is too high for my liking and the Consensus survey is showing way too many bulls (72%) compared to almost 25% last summer - when bonds finally got bids.

Also bond prices have simply come too far, too fast for me to realistically expect them to continue their pace. Looking at a 6+ historical chart, they have just descended from some very thin air territory. And with the exception of a short term buy signal in February (green arrow), they have a much higher chance of falling from here than rising.

That buy signal by the way, was a consequence of the stock market turmoil which caused people to take sell stocks and take ‘refuge’ in bonds.

The blue arrows mark the month of May in each year when bond seasonality turns positive.

Darn, I meant to post this yesterday but, ran out of time. Now it won’t seem as brilliant but what the heck…

After the recent panic selling, the relationship between stocks and bonds got out of whack in a major way. Basically, relative to each other, stocks were very cheap and bonds very dear.

This usually happens when investors and traders panic - they flee to the “safety” of bonds, pushing their prices up. But what we saw in the recent rout was monumental. We’re talking several standard deviations.

So to answer Keith’s question whether bonds are a sell, I’d say yes, although equally important: stocks are a buy.

After today’s gap down, we have an island reversal (see chart below). I was going to write yesterday that it looks bonds spiked up to 122.81 in an exhaustion gap. After the fact, this seems obvious. Nevertheless, according to Japanese candlestick patterns, it is still bearish.

The last time I hollered that stocks were a buy and bonds a sell was at the start of December (see chart above). It was a bad call on the stocks side, but good for the bonds, since they tumbled to almost 113.

Bond prices (30 year US government) have not been this high since the summer of 2003 (high of 121.67) and the summer of 2005 (high of 119.72). So prices poke their head just above resistance (taking out a lot of stops) and then headed back down.

According to sentiment, it is time to sell bonds (and buy stocks).

Bond Market Sentiment
A few days ago the Hulbert Bond Newsletter Sentiment Index reached 47.4% — that’s four times the average sentiment over the past year and eerily enough, it is a repeat of what happened last year at this time. We had a slightly higher level of bullishness last November as bond prices carved out a major top.

Two other bond sentiment measures also show a dangerous level of bullishness. Market Vane sentiment survey shows 68% bulls - you’d have to go back to 2005 to find a higher level. And Consensus Sentiment shows 63% bulls, down from a recent peak of almost 80% but still quite high.

According to contrarian analysis, you want to fade the crowd and that would mean selling bonds.

Chart Request
In the comments section of my update on the timing the stock market using the rate of change of the 10 year T-Bonds, scood asked for a chart of the same covering the 2001- 2004 timeline:

It depends on how you want to interpret that signal. One could see it as a failure or success since price meandered before continuing to rise again. If you want to be really strict, it could be interpreted as a failure since price didn’t immediately go up.

In any case, nothing is 100%. This and other indicators are mere guides and should only be used as such.

There is an inter-market relationship between bonds and gold which may not be evident at first glance. The reason why the two disparate markets are connected is that they both rely on one factor: inflation. Or the expectation of future inflation.

For this reason, it is very rare for these two markets to go in different directions in the long run. Instead, they tend to dance around each other.

When the market expects future inflation to be higher, gold mining stocks rise and bond prices fall (yields rise). So in effect, by watching one market, we can attempt to gain insight into the other.

Jay Kaeppel developed a simple system to do just that. He looked at the 12 month rate of change (ROC) in the GMI (Barron’s Gold Mining Index) and compared it to the 12 month performance of bond prices going forward. We can substitute the Amex Gold BUGS Index (HUI) for GMI.

When the ROC for the gold index is positive and high, we would expect bond prices to decline going forward (next 12 months). Conversely, when the rate of change for HUI is negative or low, we’d expect it to be a great time to buy bonds. And this is generally what happens according to historical data.

Be sure to check out Kaeppel’s original article on this: Maximizing Bond Fund Profits. You can find it in the Reports & Articles section of my free trading resource “goodies box”.

So what is this simple intermarket relationship telling us now?

Well, as far as I can tell, the bond market and the gold market have decoupled. I can’t seem to find any meaningful relationship between them now. Kaeppel’s article was written in 1994 so it only included data until then. By looking at data from the late 1990’s to today, it seems that the two markets have gone their separate ways. Atleast for now.

For example, in the summer of 2002 when the 12 month ROC for the HUI index was astronomically high, bond prices actually were higher a year later. And in the summer of 2005 (see graph below), when the 12 month ROC was negative (-40%), bond prices actually peaked and were lower a year later.

Click to Enlarge Graph

Strange. As I’ve mentioned before, although the bond market is pricing in future expectations of inflation, other markets, like gold, silver, and the CRB commodities index are breaking down and not confirming this. What to make of this?