Bulls Beware: Bond Action Casts Doubt on Stock Rally
As stocks heap egg on the faces of the bears, the bond market is still not on board with equity market gains.
By Michael Kahn
I have been on the wrong side of the stock market this month, but even now, after a 12% rally, I am not ready to cave.
Strangely comforted by the John Maynard Keynes observation that “markets can remain irrational longer than you can remain solvent,” all I can do is continue to read the evidence that the market provides. This time, however, it is the bond market that is offering the signals.
If the stock rally that began in February is more than just a response to extreme pessimism that gave way to a short-covering rally, we have to ask why Treasury bonds are still in a long-term bull market.
The pullback since bonds peaked and stocks bottomed was significant, but little or no money flowed out of the iShares 20+ Year Treasury Bond exchange-traded fund according to the on-balance volume study (see Chart 1).
On-balance volume keeps track of volume on up-days minus volume on down-days and serves as a proxy for both demand and money flows. While prices are down and yields are up since early February, on-balance volume is more or less where it was before.
Further, the ETF continues to trade above its 50-day moving average and is still well above a trendline drawn from the major December 2014 low. And now, it shows signs that it is ready to break out to the upside from its February-March correction.
Utilities stocks concur. Despite the Treasury market pullback, the dividend-rich Dow Jones Utility Average poked its head above its January 2015 peak to set fresh all-time highs.
And while the Utilities Select Sector SPDR ETFhas not yet moved through resistance to an all-time high of its own, its on-balance volume profile could not be any stronger (see Chart 2). This indicator moved higher throughout much of last year’s choppy trading and exploded to the upside this year.
For whatever reason, utilities remain a strong sector without becoming overbought or even creating excessive optimism.
It may seem that this sector is stretched to the upside and in danger of a reversal, but long-term signs such as momentum and trend tell us this is still a healthy bull market.
Within the bond market we can compare the performances of high quality and low quality, aka junk, corporate bonds. Corporate bonds, especially of the junk variety, have been very stock-like in their trading for several years. They rally when investors feel frisky and are willing to take bigger risks. Treasury bonds often moved in the opposite direction due to their lower yields and more defensive profile.
By looking at a performance ratio within the corporate bond market, we can get a feel for investor risk desires. Right now, the ratio of the iShares iBoxx $ High Yield Corporate Bond ETF to the iShares iBoxx $ Investment Grade Corporate Bond ETF is still below its most relevant trendline from last year’s peak (see Chart 3).
Granted, it has held near the trendline for several weeks and still can break out to the upside, but that
has not happened yet. And even if it does, the 200-day average of the ratio is not far above. In other words, the performance of junk bonds relative to quality corporate bonds faces strong technical resistance. That suggests that the recent rally was more of a reversion to the mean than anything else.
A strong Treasury bond market and a continued downtrend in investor desire to take on too much risk suggest the bond market knows something the stock market may not. Strong breadth in the stock market, as I covered last week, is certainly not bearish, but when we look at the total picture of the financial markets there is still reason to worry.