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Wag the Dog

Wag the Dog

Courtesy of Rom Badilla, Bondsquawk.com

Fueled by positive earnings surprises, the equity markets have soared giving the bulls reason to run. Last week’s gain of 3.5 percent for the S&P 500 is the second highest weekly gain in 2010. Since the recent lows set at the beginning of July and the onset of earnings season, the S&P 500 has advanced an astonishing 7.8 percent to 1108.9 as of this morning.  While the jump has been spurred by fundamentals as many of the companies so far have surpassed analysts earnings forecasts, even the technicians have reason to believe in the strength of this rally. As past support levels become layers of resistance, the S&P 500 blew past prior lows of 1040 and 1065 in addition to the 50-Day moving average at 1085.  Even with the “Death Cross” pattern starring at the many faces of investors, the S&P 500 is making a push to its next layer of resistance at the 200-day moving average of 1110-1115.

While the rally may have some legs to it in the near term and as we enter the second half of earnings season, there are other markets that continue to keep their eyes on the ball as for determining the fate of the U.S. economy.

The 2-Year Treasury which is more in-line with the Federal Reserve’s monetary policy and is heavily influenced by macro drivers, remains unimpressed with the recent bull run in stocks.  Despite the long-end of the yield curve selling off and retreating from recent highs due to a lack of conviction as reflected by the Merrill Lynch MOVE Index, the 2-Year has not moved much at all.  Last week, the 2-Year remains unchanged at 0.58 percent.  Going back further to the onset of earnings season and while the S&P climbed from its recent lows, the 2-Year has declined 2-3 basis points.

Indeed this shouldn’t be surprising to those who follow from ten thousand feet above, since the Federal Reserve maintains rhetoric that rates will remain low for an extended period of time.  While the 2-Year is “anchored” by the Fed’s target rate which hasn’t changed in awhile, the fact remains that the short-end of the Treasury curve has risen on strong economic data and declined as the recovery story falters. 

From late January to the beginning of July, the 2-Year has dropped 30 basis points. During that time, the 2-Year reached a recent high of 1.06 percent in late April when the S&P 500 was north of 1215 and the economic numbers save for employment that is, pointed to stronger growth.  Since then and after the recent spate of disappointing macro data, the two year has dropped close to 50 basis points while stocks have fallen.

It is paramount to note that the relationship, which exhibits a high correlation, held up until the beginning of July and before equities started to take its cue from earnings (The correlation on a change basis for the trailing 6 months stands at 0.57 and at 0.83 by using just the values.  1.0 reflects perfect correlation and -1.0 shows having an inverse relationship).

2-Year U.S. Treasury Yield & the S&P 500 – Trailing 6-months

The bulls may think that the worst is behind us given the fact that the market is “forward looking” and is in general, a reflection of the overall U.S. economy.  Indeed, there is evidence from a bottom-up point of view that the recovery should continue.  However, we all should know that the tail should not “wag the dog” as earnings and profits of each and every company are a byproduct of the general economy.  In addition, earnings which are “rear view” in nature are coming in higher due to beaten down expectations.

The fact remains that the macro picture is revealing an economic slowdown and as Bernanke stated last week that the outlook remains “unusually uncertain.”  As we all know, the bulls hate uncertainty and require comfort much in the same way, I need a cushy pillow for a good night’s rest.

Having said that, it appears that rest is a luxury that the U.S. economy cannot afford.  As David Rosenberg of Gluskin Sheff pointed out that, “80% of the economics community has cut GDP growth forecasts to an average of 2.5% for the rest of the year from the 3% call in April – not to mention that over 80% of the economic indicators over the past month have come in below consensus estimates.”  In addition, ECRI has fallen off a cliff as mentioned here last Friday.

The many who follow us here on Bondsquawk, should know that price is the true arbiter of value for any investment.  Respectfully, the recent rally in stocks (on low volume that is) should not be discounted.  However, if we look at it with the proper and broader context, it is apparent that the 2-Year is suggesting something completely different from its equity counterpart and that the economy is still facing significant headwinds. 

 


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