The October Bond Bull Surprise?
U.S. stocks rose Friday as better-than-expected third-quarter earnings reports boosted the Dow Jones Industrial Average to its best weekly performance since June.
The Dow Jones Industrial Average gained 382.20 points, or about 1.1%, to 35,294.76. The S&P 500 added roughly 0.8% at 4,471.37, and the Nasdaq Composite rose 0.5% to 14,897.34.
The three major indexes closed the week higher and are positive on the month.
The Dow sat 0.9% below its all-time high. The S&P 500 and Nasdaq Composite were 1.6% and 3.3% off record highs, respectively.
Third-quarter earnings reporting season continued Friday as Goldman Sachs’ results beat significantly on the top and bottom line. The bank stock gained 3.8% and was the top gainer on the Dow.
The stellar report came after earnings beats from other big banks earlier in the week. Financial heavyweights JPMorgan, Bank of America, Morgan Stanley and Citigroup were among the firms topping expectations.
“The banks painted a strong and healthy picture of the US consumer,” said Edward Moya, senior market analyst at Oanda. “Wall Street can’t turn negative on the economy after seeing reserve releases, moderating trading revenue, mixed loan growth, and a consumer willing to take on debt.”
As of Friday, 80% of the 41 S&P 500 companies that have reported third-quarter results have topped earnings-per-share expectations, according to FactSet. Taking into account these results and estimates for those yet to report, the blended third-quarter earnings growth rate for the S&P 500 is 30%, FactSet analysis shows.
Retail sales posted a surprise increase in September, rising 0.7%. Economists polled by Dow Jones were expecting a 0.2% decline.
“The inflation environment and concerns about supply chains have not put a strong dent in retail sales,” said Yung-Yu Ma, chief investment strategist at BMO Wealth Management. “Consumers are acclimating to higher prices. So far that hasn’t resulted in a meaningful fall-off in demand. But this willingness to absorb higher prices is not unlimited.”
Elsewhere, bitcoin crossed the $60,000 level as investors were optimistic about the chance of the U.S. Securities and Exchange Commission approving the first bitcoin futures exchange-traded funds.
The cryptocurrency’s jump added to positive market sentiment, suggesting risk-taking could pick up. Tesla added 3%, and Coinbase shares rose 7.9%.
The strong earnings from big banks powered the Dow higher this week but if you drill down into sector performance, materials (XME) lead the charge, gaining 3.64%, followed by Consumer Discretionary (XLY) which gained 3.55% (mostly owing to Amazon) and real estate shares (XLRE) which gained 3.52%:
In fact, financials (XLF) even underperformed industrials (XLI) and utilities (XLU) this week but posted a gain of 1.23%, just beating out staples (XLP) and energy (XLE) shares.
The big story this week was bonds. The 10-year note yield fell from 1.61% at beginning of week to a low of 1.51% on Thursday, powering tech shares (XLK), utilities (XLU) and real estate (XLRE) higher:
If you look at the 5-year weekly chart of the iShares 20+ Year treasury Bond ETF (TLT), you'll see it's at an important level here and it has to cross it for bonds to continue rallying:
Keep in mind, TLT reflects long bond prices which move inversely from bond yields (as yields go lower, bond prices go higher).
Why is it important to watch bond yields here? Simple, when bonds rally (ie yields fall), investors allocate more to risk assets, including tech shares and when bonds sell off (ie. yields rise), that typically means economic activity is picking up and cyclical shares rally (industrials, financials, energy and materials).
This week, however, materials posted great gains on the back of great earnings from Alcoa (AA):
It's not just Alcoa powering materials higher but look at that chart above, just a spectacular rally after bottoming near $5 in March 2020.
When people tell you "never buy a falling knife", it really depends, that's one falling knife you definitely should have bought hard!
But that's all fine and dandy, where do we go from here?
Well, I urge all my institutional readers to read a few things. First, Francois Trahan's latest (It's Different This Time...And Why It Just Might Be Real ") because he goes over in detail 7 things that are different in 2021:
Number 3 caught my attention as he notes this:
And he's not the only one warning of potential inflation coming from housing. Mitch Bollinger of Markov Process International (MPI) notes this on Linkedin:
With CPI coming in hot recently, I wanted to explore the historical relationship between CPI growth and stock valuations using the CAPE. See the first chart shows that not only is the CAPE high by historical standards, but it in an extreme outlier position when conditioned on 1 year CAPE growth. Historically with this level of CPI growth, the CAPE is in the 10-ish to low 20-ish range which would require stock valuations to be around half of where they currently are.
For those who will point to the base effect of CPI growth over 1 year, see also the same chart but for 2 years which gets us pre-Covid. The valuations do not look as extremely but still very pricey.
As for inflation being transitory, consider that more real time rent numbers lead CPI shelter suggests CPI shelter so CPI shelter is quite predictable several months in the future. This relationship suggests CPI shelter will be in the 6% range in the next few months. The fact that CPI shelter makes up 41% of core CPI implies even if other components of core CPI increase, the expected rate of increase will not decrease any time soon. If stocks get this memo, it could get interesting.
We shall see if core inflationary pressures pick up and stocks "get the memo" but it is interesting that so far, all the dips keep being bought hard and stocks keep getting ramped up.
But before you jump to any conclusions, take the time to read Hoisington's latest quarterly review here.
These guys have been right on bonds for years and they know what they're talking about.
The latest comment is superb but I will skip to the conclusion:
The U.S. economy has clearly experienced an unprecedented set of supply side disruptions, which serve to shift the upward sloping aggregate supply curve inward. In a graph, with aggregate prices on the vertical axis and real GDP on the horizontal axis, this causes the aggregate supply and demand curves to intersect at a higher price level and lower level of real GDP. This drop in real GDP, often referred to as a supply side recession, increases what is known as the deflationary gap, which means that the level of real GDP falls further from the level of potential GDP. This deflationary gap in turn leads to demand destruction setting in motion a process that will eventually reverse the rise in inflation. In the 1970s, the economy was beset by a string of such supply curve shifts primarily because of falling oil production. Then the inflation rate did not fall but continued to march higher. However, before Paul Volcker was made Fed chair late in the decade, the Fed actions allowed money supply to accelerate steadily. During the 1970s, unlike currently, the velocity of money was stable (although not constant). As a result, the aggregate demand curve (C + I + G +X = M x V) also shifted steadily outward. This allowed the inflation from the supply side disruptions to become entrenched. Currently, however, the decline in money growth and velocity indicate that the inflation induced supply side shocks will eventually be reversed. In this environment, Treasury bond yields could temporarily be pushed higher in response to inflation. These sporadic moves will not be maintained. The trend in longer yields remains downward.
Again, take the time to read their entire comment here, it provides a lot more detail.
If the trend in longer yields remains downward, buy QQQs, tech shares will continue to rally.
However, if inflation remains a lot more stickier than what many anticipate, raise your cash levels and prepare for a lot more volatility.
On that last point, in his latest weekly market wrap-up, Martin Roberge of Canaccord Genuity looks at the inflation pipeline test and notes this:
Our focus this week is on push-through inflation using input prices by stage of production provided in the PPI report (see our Chart of the Week, second panel). While no longer accelerating on a YoY basis, producer prices are not showing signs of an imminent reversion to the mean, especially when considering the ongoing flare in energy prices. Another driver supporting the CPI is housing, which accounts for ~30% of the headline index and ~40% of the core CPI. For the record, we foresee housing-related inflation to top 4% YoY next spring (third panel). Importantly, the Fed appears increasingly cognizant that price pressures are likely to prove less transitory than anticipated, with the FOMC minutes showing that some “participants saw inflation as likely to remain elevated in 2022 with risks to the upside”. In all, a Fed tapering announcement appears imminent, in our view, which can be interpreted as the beginning of a tightening cycle that should bring US 10-year Treasury yields to the 1.75-2% range. This range could mark an interim peak as 2022 growth prospects appear increasingly vulnerable to demand destruction caused by rapidly rising energy prices, especially in Europe and Asia. In any case, we think investors should start hedging against central banks falling behind the inflation curve. This will become more pressing when the correlation between gold and yields turns positive.
There are a lot of moving parts here but let's wait and see how the rest of earnings season goes.
So far, so good, but keep your eyes peeled on long bond yields, if they start backing up, volatility will pick up and stocks will sell off.
Below, as bullish analysts predict a major market rally into year-end, the Halftime Report's Investment Committee discusses one call that says we could see a more than 10 percent correction.
More importantly and more interestingly, Bloomberg Opinion columnist and Queens' College President Mohamed El-Erian fears that a sharp rise in economic inequality puts society at risk of creating a 'lost generation.' He tells Bloomberg's Sonali Basak that we may see the inequalities exposed by Covid-19 worsen in the years ahead.
If you ask me, rising inequality is deflationary and it's only going to get worse in the years ahead. This too is ultimately very supportive of the secular trend in lower long-term bond yields.