C.M.O. 9.6.2011

When the Tech bubble was still inflating you heard the term “Paradigm Shift” used to describe the new way in which everything would be done.  The term was meant to describe big things moving in big ways.  There are big things moving in big ways these days too but it would probably be better described as Tectonic Plate movement as entire continents are being moved by the same economic forces.

Evidence of these shifts can be found in the stock market as the correlation among components of the S&P 500 has hit 80% according to Ana Avramovic of Credit Suisse, which is even higher than the 73% peak reached in late 2008.

Of the explanations given for this, one is that more than 30% of the volume on U.S. stock markets is a result of ETF trading these days as compared to just 2% at the turn of the millennium.   While that might be the case when you have days like August 8th where every stock in the S&P 500 was down and the NYSE advance/decline line had a 1:589 ratio to the negative it would appear there is a little more than ETF trading going on.

Another sign of tectonic action is that Ned Davis Research counted 5 days in August when the A/D ratio was 1:10 and another 5 when it was 10:1.  Not much stock picking going on there.

The herd mentality might better be described these days as a school mentality, as in a school of fish that darts one way and then the other with the slightest provocation.  News last Monday that two Greek banks were merging boosted the Athens General Index by 14% which triggered a global “up” day in equity markets.  From a different perspective it would seem more apropos to describe that combination as two bricks, not two banks, as the state of the Greek economy would appear to make it unlikely that any loan will be repaid so if one brick won’t float it is tough to see how two tied together will.

Additional evidence of the current state of distress can be found in the synchronization of the stock and bond markets as the stock market has recovered much of what was lost after Standard & Poor’s downgraded Uncle Sam’s debt while the U.S. Treasury market has benefited from the fear that while it might be bad here, its worse everywhere else.

Eric Green, chief interest rate strategist for TD Securities says, “We have a disconnect here, bond guys are a bit more cynical and when I look at the equity market, I see something slightly different – they are more hopeful.”  The cynicism that Mr. Green associates with the “bond guys” might also be questioned as Dan Greenhaus, chief global strategist at BTIG thinks the shape of the yield curve is what is giving the “stock guys” their hope.  “Yields down at these levels still reflect some nervousness, but the curve is much steeper today than anything you got in 2002, 2003, signaling a better economic environment going forward”, he says.

Acknowledging that the yield on the two year note is anchored to the Fed’s zero-rate policy it should be noted that the difference between the 2-year and thirty year bond is currently 332bps which is over twice the 158bp average that existed from 1990 to 2010.  The 5-year:30 year spread adds more weight to the argument as it is currently 260bps which is up from 40bps in early April.

This could all change direction as quickly as that school of fish changes direction as there is reason to believe that while we might not be getting QE3, we could be about to see Twist 2.0 as described by Randall W. Forsyth in this weeks Barron’s.  Mr. Forsyth harkened back to the early 60’s when Chubby Checkers created the craze around the popular dance of the time.  The Fed was doing its own twist back then by buying longer dates Treasuries and selling shorter dated ones.  The cynics in the bond market borrowed the name from C.C. and applied it to the Fed’s maneuver.

With dissention already at historic levels among the Fed governors, changing the focus of securities purchases might be the best way for Ben B. to not only keep rates low but also flatten the curve in the process.

The question that has to be asked then is that if a steep curve signals “a better economic environment going forward” as Dan Greenhaus says, does a flatter one become a self fulfilling prophesy and portend a downturn in the economy?

Swim with the fishes if you like, just don’t get hooked.

Leave a Reply

Your email address will not be published. Required fields are marked *