Friday, April 18, 2008

New Decoupling Theory: The Stock Investor and The Bond Market

Sorry its been quiet around here. I have had some business meetings the past few days.

Well the bulls were charging again today on Wall St. This market gets wackier and wackier by the minute. What I see developing late this week in the markets is something investors really need to focus on. The bond market is telling us they are about to lead the bulls right into a slaughterhouse

We all have been heard about the global "decoupling theory" on CNBS where the global economy will "decouple" from us and continue to grow and offset our losses as we head into a recession.

I now believe we have another decoupling going on right now in the markets. The bond market is starting to decouple from the the stock market and its investors this week.


Becsause the bond market is screaming FEAR at the top of its lungs. How is it screaming fear? Well all you need to do is take a look at the big move in the Libor rates this week and the huge jump in the prices of the 2 year treasuries. Remember the Libor story I shared with you from the WSJ and Bloomberg? Well the Libor rose dramatically as expected because the banks were lying to each other and the regulators put an end to it.

This made the bond market nervous because it shows them the banks are scared and not lending to each other. Then the bank earnings came out this week. After seeing these they went from being nervous to flat out being scared. This fear was seen in 2 year treasury note as it started soaring this week. This is not good.
Its described well here on Bloomberg:

"Two-year yields have risen 45 basis points this week, the most since November 2001, on speculation the Fed will reduce its target rate by a quarter percentage-point on April 30, instead of the half-point traders expected a month ago.

"The drop in two-year notes ``is related to the issue with Libor, and it's forcing down the short end of the curve,'' said Theodore Ake, head of U.S. Treasury trading at Mizuho Securities USA Inc. in New York. ``People are really worried about the implications of the Libor mess; unlike the previous times when they didn't know what to do and bought two-year notes, this time they're selling two-year notes and trying to get into cash.''

Theodore explains it perfectly. People in the bond market are flying into cash. This tells you that the bond market has had enough of the Wall St. bank's accounting games. So as the average investor is flying into stocks as the talking heads on CNBC tell them we have hit the bottom, the bond market is running into cash. I will say it again. ALWAYS FOLLOW THE BOND MARKET because they almost always get it right.

So why is the bond market running into our cheap dollar? Well when the bond market starts seeing big companies like Citibank taking huge losses, they have now decided to run for the hills and head to cash instead of being a fool and chasing stocks that are falling apart. This flight to safety is telling you they think this market is deteriorating and they have lost confidence in it. They would rather be in cash versus owning treasuries.
Take a look at Citi earnings:

"Citigroup, the biggest U.S. bank by assets, reported almost $16 billion of trading writedowns and increased bad loan reserves as customers fell behind on home, car and credit-card payments.

"Revenue fell 48 percent to $13.2 billion, compared with the average estimate of $11.1 billion from analysts surveyed by Bloomberg. Results included $7.6 billion of writedowns and credit costs on mortgages and bonds, $1.5 billion on leveraged buyout loans and $1.5 billion on auction-rate securities.
The bank wrote down the value of assets it absorbed last year from so-called structured investment vehicles by $212 million and marked down the value of bond insurance contracts by $1.5 billion.

Standard & Poor's said today it is reviewing Citigroup's rating for a possible downgrade, noting that earnings may be further depressed by loss reserves on the bank's loan portfolio. Fitch Ratings lowered the company's rating one level to AA- from AA today, with a negative outlook. Fitch cited deteriorating earnings in the consumer business and investment bank losses."

These numbers are obviously terrible. Citibank also said they may have to raise new capital when they previosly had said there would be no need to. So how did the talking heads onWall St. react?

``Pandit is doing what needs to be done, focusing on capital management, allocating capital to areas that he wants to grow and exiting businesses that he doesn't think are core to the overall franchise,'' said Peter Kovalski, portfolio manager at Alpine Woods Investments.

``People are assuming the worst,'' Walter Todd, a portfolio manager at Greenwood Capital Associates, said in an interview on Bloomberg radio. ``Expectations are low enough that you can have some positive stock performance even off a bad number.''

Pandit ``is doing the right things in our eyes,'' said William B. Smith, president of Smith Asset Management LLC in New York, which oversees about $80 million, including about 66,000 Citigroup shares."

My Take:

Wall St. cheered the news while the bond market said "Oh my god look at these numbers" and ran. The bond market See's a company with a 50% revenue drop that may need to raise capital after taking huge losses. Wall St's sees these stocks as buys. The reactions above reactions are ridiculous when you look at the numbers. They are telling you to buy because the "Expectations are low enough that the stock will rise" and "Pandit is doing the right things". I guess I would say the same thing if I owned 66,000 shares of Citi.

I heard the same "buy because the bad news is priced in" a few months ago when Citi was at $30.

If the bond market is starting to fly into dollars then its telling you something. They realize things are ugly when you have massive write downs, rising libor rates due to fear, and 50% reductions in revenues in Citi. When they see this on top of a weak consumer, slowing economy, and rising inflation, things look even uglier.

After seeing a good chunk of the bank earnings this week, its obvious the bond market is questioning the solvency of these banks and probably earnings in general in the stock market and rightly so.

As Wall St. and the bond market are decoupling, decouple with the bond market. If they are scared then you should be as well.


Avl said...

Ya gotta love the "Bigger Fool" theory when looking at the DJIA and S&P 500 "rallies" of 2007-08

As 2008 prods along, lotsa guys are snickering, "I Drink Your Milkshake!"

Jeff, Remember the Wall Street history I shared with you that showed almost a 48 month gap between the 1st major crash of Oct. 1929 and the final trough?

Jeff said...


I agree. The bulls could party on for a bit.

I think that we will see DOW 9000 before going above DOW 14k. 20 years from now we will be way above 14k.

Even Jim Cramer said "sell" today and talked about preserving capital.

We are near the end of the final trough IMO.

I would never short in this situation.

This is a time for cash. Longs and shorts are simply speculating.