Black Swan Insights

The recent rally in equities has certainly been impressive to say the least. But what interests me is the major divergence developing between equities and bonds. In addition, the general stock market has now decoupled from financial stocks. Together, these negative divergences may indicate that something is not quite right with the market's relentless rally. In fact, it feels a lot like the last melt up back in April 2010, when the market was completely ignoring Greece's imminent collapse. The difference is that the market's rise has been based on QE 2, which it is believed will support higher asset prices.

Below is a chart which compares the 10 Year Treasury with the S&P 500. I have previously showed this chart and commented that one markets is going to be wrong. You cannot have both surging equity markets and rising bond prices indefinitely. Why? Because you buy stocks when the economic outlook is favorable, and you buy bonds when the economic outlook is bleak. You can't have it both ways. Bonds are signaling economic problems while the equity markets are completely drunk on QE 2.

Click charts for larger image.

Below is a chart which compares the XLF (financials) to the S&P 500. You can see that until recently they have moved in perfect unison. Financials are an important sector for the general market as they led us on the way down back in late 2007 and early 2008. They were also the initial leaders off the March 2009 lows, so they are worth keeping your eye on. If financials continue to falter, it is hard to imagine that the market can continue to melt up.

Black Swan Insights

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One of the more bizarre contradictions during the recent rally in equity markets is the complete refusal by the bond market to budge from its deflation/recession view. In most cases, the equity and bond markets trade according to the same economic outlook. If the market believes inflation/growth is on the way, stocks rally and bonds fall (yields rise). Conversely, when the outlook is for deflation/recession, equities fall and bonds rise (yields decline). However, there is currently a deep divide today as the stock market (and commodity market for that matter) trades like growth and inflation are on the way, but the bond market is holding to its deflation/recession view. Below is a 3 year chart which compares the 10 year treasury to the SP 500. You can clearly see that while the two can briefly diverge, they eventually converge on the same economic consensus. So the question is which market is right and which one is wrong? To be honest I really don't know at this point. I think the reason for the large divergence is caused by the Fed's buying of treasury bonds, which has distorted the market. What I do know is that when these two converge, you are going to see some large moves in these markets. If bonds stay where they are then stocks could easily fall back down to between 800-900 on the SP 500. However, if bonds are wrong we could see the 10 year at 3.5-4%, which would be bullish for stocks.

Click chart for larger image.

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Words of Wisdom from Leonardo da Vinci

1. I have been impressed with the urgency of doing. Knowing is not enough; we must apply. Being willing is not enough; we must do.

2.Simplicity is the ultimate sophistication.

3.Life well spent is long.

4.Life is pretty simple: You do some stuff. Most fails. Some works. You do more of what works. If it works big, others quickly copy it. Then you do something else. The trick is the doing something else.

5. Marriage is like putting your hand into a bag of snakes in the hope of pulling out an eel.

Black Swan Insights

Some Negative Divergences To Keep Your Eye On

Who Is Going To Be Wrong: The Bond Market Or Stock Market?