Investors Flee Bond Fund
When the world's largest bond fund sees over $7 billion in net outflows, it
tells us the tide may have turned against the bond market bulls. From Bloomberg:
The world's biggest mutual fund keeps getting smaller. Bill Gross's Pimco
Total Return Fund shed $41 billion, or 14 percent of its assets, in the
past four months through losses and investor withdrawals. The fund suffered
$7.7 billion in net redemptions in August, Chicago-based researcher Morningstar
Inc. (MORN) said today in an e-mailed statement, the fourth straight month
of withdrawals.
Economy Holds Key To Bonds' Fate
As we have documented on numerous occasions, the Federal Reserve has clearly
signaled it would prefer to step away from non-traditional forms of stimulus
in order to avoid another round of asset bubbles. The only question is will
the economy be strong enough to withstand a complete wind-down of the Fed's
bond buying program. If the Fed implements according to their previously
mapped-out tapering timeline, bonds may suffer further. From the Wall
Street Journal:
Studies for the Financial Industry Regulatory Authority's education arm
and, more recently, Edward Jones have revealed a majority of investors
don't know that when interest rates rise, bond prices typically fall.
If the economy is strong enough, interest rates will continue to creep higher.
If interest rates creep higher and the majority of investors do not know rising
rates can negatively impact bond prices, it stands to reason that additional
selling in the bond market will come as the losses pile up.
A Signal of Economic Confidence?
Small cap stocks have been market leaders since the November 2012 lows, which
typically shows a bias toward improving economic outcomes. Similarly, if a
small business owner is willing to borrow and invest in their business, it
tends to signal confidence in business trends. From Reuters:
Small U.S. businesses took on more debt in July, pushing an index of
borrowing to a six-year high and adding to evidence that the economic recovery
is on firmer ground. "There is some optimism returning to small businesses...they
are responding to some demand," PayNet President Bill Phelan said in an
interview. "As long as interest rates are within reasonable boundaries....a
strong economy with demand is better than a weak one with low interest
rates."
Therefore, small cap stocks and small business borrowing provide some anecdotal
evidence supporting the improving economy case, which could mean higher interest
rates and more pain for bond investors.
Car Sales Align With Bullish Economic Case
Just as a rising borrowing index tends to signal confidence rather than fear,
consumers that are willing to take on a new car payment are also demonstrating
confidence in their economic futures. From Reuters:
U.S. auto sales were on a pace to show a gain as high as 17 percent in
August as the industry raced toward its strongest month since just before
the start of the 2007-2009 recession. "The auto industry continues to be
a bright spot in the economic recovery," said Bill Fay, Toyota division
group vice president and general manager.
The Market Has Spoken...Well, Sort Of
Investors and consumers have been known to exhibit confidence just before
bearish turning points, which means the anecdotal evidence above may turn out
to fall into the "false signals" folder. Our market
model, which examines the current battle between risk tolerance and risk
aversion, paints a much more balanced picture. As of Tuesday's close, the model's
recommended exposure between risk assets and conservative assets was an even
50-50% split. The back and forth battle between bulls and bears can be seen
in the chart below, which tracks the demand for stocks relative to the demand
for bonds. The ratio has made no progress in either direction since early July.
Investment Implications - Ready To Migrate
If you pay attention to what is happening, you will not stray too far from
the market's asset pricing mechanism. That mechanism has said "reduce risk
to account for the uncertainty, but do not redeploy your cash into conservative
investments yet." We have done just that by holding about half of our allocation
in stocks (SPY) and leading sectors (QQQ), while offsetting the risk with high
cash balances. When the markets begin to support the bullish or bearish case
with conviction, we will migrate in a manner that allows us to remain in the
pricing mechanism's neighborhood.