Stocks want to go to the party, but bonds won’t go in the car

We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.

My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

• Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
• Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
• Trading model: Neutral (Last changed from “bullish” on 11-Oct-2023)

Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
 

Subscribers can access the latest signal in real time here.

Valuation pressures

Technical analyst Helene Meisler aptly characterized this market last Thursday as “Stocks want to go to the party. But the bonds won’t get in the car.” I agree.

The equity market appears to be enjoying fundamental and technical tailwinds, but rising Treasury yields are pressuring both stock and bond prices. Indeed, the difference between the S&P 500 forward earnings yield and 10-year Treasury yield hasn’t been this low since 2002.

 

Will these valuation pressures sink stock prices? What about the bond market?
 

 

A bond market tantrum

The U.S. Treasury is throwing a tantrum. How much of one? The 10-year yield of Greece (yes, that Greece), which is just returning to an investment grade credit, is trading lower that the 10-year Treasury.
 

 

A number of explanations have been advanced for rising bond yields. None of them are especially satisfying.
 

The evidence for the excess supply argument for the surge in yields is uneven. While the 30-year auction two weeks ago had dismal results, the 20-year auction the following week was well-received.

What about the narrative of rising yields owing to a stronger economy? The Citigroup Economic Surprise Index, which measures whether economic statistics are beating or missing expectations, is positive but decelerating while yields have surged.
 

 

The market became excited last week with the release of the TIC report which showed that China was selling its U.S. holdings. Analysts seized upon this as the reason for the upward pressure on Treasury yields.
 

 

The “China is selling story” is less bearish that it sounds. While the narrative of a modest Chinese reduction in Treasury bonds and Agencies is true, Council for Foreign Relations senior fellow Brad Setser found that China’s overall USD holdings after accounting for direct and indirect custodial accounts were broadly stable. Maturing Treasuries were rolled into T-Bills and bank accounts, which is far less ominous from a geopolitical viewpoint.

 

Fed Chair Jerome Powell’s speech last Thursday took a slight dovish tone and should be supportive of lower yields. Powell opened his speech to the Economic Club of New York on a constructive tone.

Incoming data over recent months show ongoing progress toward both of our dual mandate goals—maximum employment and stable prices.

After characterizing the jobs market as “tight” for many months and focusing on core services ex-housing inflation, which is the Fed’s code about wages pressuring the price of services, Powell seemed to switch his tone on wages.

Indicators of wage growth show a gradual decline toward levels that would be consistent with 2 percent inflation over time.

He also gave a nod to higher bond yields and their effects on monetary policy. Translation: The market is tightening monetary conditions for the Fed. This is as clear a signal a central banker can give that there will be no more rate hikes, at least in the near term.

Financial conditions have tightened significantly in recent months, and longer-term bond yields have been an important driving factor in this tightening. We remain attentive to these developments because persistent changes in financial conditions can have implications for the path of monetary policy.

From a technical perspective, Treasury prices look washed-out and appear to be ready to bottom. The 20+ Year Treasury ETF (TLT) fell to multi-year lows on enormous volume last week while exhibiting positive divergences on the 14-day RSI and money flow indicator.
 

 

 

Stocks ready to party

Over in the stock market, equities are ready to party. Even though valuation appears to be under some pressure, the reaction from Q3 earnings season is encouraging and estimate revisions are exhibiting positive fundamental momentum.

 

Jurrien Timmer at Fidelity pointed out that the global earnings cycle is turning up, which is another sign of positive fundamental momentum.
 

 

From a technical perspective, the VIX Index has spiked above its upper Bollinger Band, which is a signal of an oversold market as the S&P 500 tests support at its 200 dma.
 

 

The analysis of the weekly S&P 500 chart is equally revealing. The index is testing a long-term uptrend that stretches back to the 2020 bottom as its 5-week RSI has become oversold.
 

Goldman Sachs’ prime brokerage arm reported that hedge fund positioning is extremely defensive, which is contrarian bullish. While stocks may decline a little further from here, they don’t crash when technical and sentiment conditions are this extreme.

In conclusion, surging yields have not only cratered bond prices, but also created severe valuation headwinds for stock prices. A fundamental and technical review of the U.S. Treasury market shows that bond prices are poised for a rally. The fundamental and technical picture for U.S. equities is even brighter as fundamental momentum and oversold conditions point to a strong rebound.