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Welcome to Wonderland

Jeff Miller

“If I had a world of my own, everything would be nonsense. Nothing would be what it is because everything would be what it isn't. And contrary-wise; what it is it wouldn't be, and what it wouldn't be, it would. You see?”

—Alice, in Lewis Carroll’s Alice in Wonderland

What’s good is bad and what’s good is good, depending on where you are, you see?  When Ben Bernanke answered questions on June 19, he caused consternation in the markets by stating that the Fed would, sometime in the near future, start to “taper” its bond purchases. Not stop buying bonds and definitely not start selling them—just “tapering.” In the next four trading days, the 10-year Treasury yield moved from about 2.17% to 2.65%, faster than you could say “leveraged carry trade.” Since then, it has basically gone sideways.

The stock market initially sold off dramatically, with the S&P 500 Index declining about 5.6% in the four days from June 19 to June 24. Then, unlike the bond market, U.S. stocks changed course and started to go up again. Why? Because what is good is good for stocks. Rates are so low that an increase in borrowing costs for a strong operating business is immaterial. But a stronger economy?  That is material.  A stronger economy, where more people are employed and buying goods and services, can help drive earnings higher for most large U.S. companies because they are operating very efficiently.  Hence, an X% pickup in revenue could easily lead to a 1.5 or 2 times X% pickup in earnings. That’s powerful.  And it took the stock market a few days to remember that what is good for the economy is good for stocks, taper or no taper.

Even in Wonderland, endings are inevitable, as its king stated:  “Begin at the beginning … and go on till you come to the end: then stop.” This is proving a harder truth for bond investors to accept. The bond market, unlike the stock market, clearly is afraid of the end of quantitative easing (QE). Rates are extremely low by historical standards. The last time they were this low for this long was in the early 1950s. If you are long a lot of plain vanilla bonds, higher rates mean lower prices for your holdings—the math is brutally simple.  Sure, you can hold them to maturity, but do most investors really want the current paltry yield of the 10-year Treasury for the next 10 years?

Since 2008, many investors simply may have been trying to avoid losing their proverbial heads. It brings to mind a conversation between Alice and the Cheshire Cat.  Alice asks which way to go from here, but admits she doesn’t much care where she goes. I think a lot of investors have not much cared which way they went during the past five years, so long as their investments didn’t go down. Investors are now learning that not caring which way they go from here can lead to losses in bonds as well.

Bond investors are justifiably skittish. I think that many have quite a bit of cognitive dissonance going on right now,  not unlike the White Queen, who sometimes “believed as many as six impossible things before breakfast.”  Bond investors have seen some losses, but now those losses have  stopped (for the time being).  For about month, stocks have been trading in a narrow range, but intraday, there have been mini-rallies and sell-offs based on the bond market, which has been moving based on rumors of a taper starting in September versus December.

Really? The markets care that much about whether the Fed tapers in one month or in four? Apparently, yes, it does. The bond markets are in such a state that a three-month difference can send yields higher (or lower) and send stocks in the opposite direction, at least in the very short run. These bond market moves are usually based on a parsing of the speeches or testimony of various Federal Reserve governors, leading bond “investors” to pay more attention to rumors than to fundamentals. This is certainly one way down the rabbit hole, as the Fed has warned about for years, including  in 2002, when then-Governor Bernanke’s commented on the “unhealthy tendency of investors to pay more attention to rumors about policymakers’ attitudes than to the economic fundamentals that by rights should determine the allocation of capital.”

Right now, Ben Bernanke and the Fed are trying to wean markets off of QE and get them focused on the idea that a taper will begin if—and only if—the U.S. economy is getting stronger and notably better than it is today. A stronger economy will be good for earnings and, presumably, good for stocks and the stock market, which should ignore the bond market noise and focus on fundamentals. What’s good is good again.

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