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Tuesday, February 26, 2013

Bonds Technical and Sentiment Picture


Following post was written on Sunday night but was not published due to logistic reasons. Yesterday's market action has further solidified the rally argument. It could have far reaching consequences for the stock market (we will discuss those later). In the mean time, I would like to again humbly Thank God, who enabled the IPM Model to predict this decline in the stock prices and allowed us to stay out of the market. IPM Model predicted the bottom at the next IPM Turn window in January, after which all of the subscribers exited the market, with  a goal to buy back at lower prices. Past reports will be published in March. (Subscription Information)


For the last few days, we have been discussing the Bond market. Bond prices bottomed on Feb 1, 2013, and have since been going sideways. This sideways action can mean two things:

1- Market is getting ready for another decline
2- Market is tracing out a base before breaking out.

In order to better understand bond market's recent price action, one should look at the bigger picture and the long-term bond market structure.


Long term Structure:
Long term Bond market structure clearly shows that Bonds have been declining since July of 2012 (almost the same time when stock market started going up in summer). This decline has traced out a clear 3-wave (A,B,C) structure. Furthermore, the structure is not impulsive at all, with wave A sub-divided into 3 waves, wave B sub-divided into 3 waves and wave C ongoing. As we know that 3-waves are corrective in nature, therefore, it is highly likely that the Bond market will very soon complete its correction (might have already completed its correction) and start a sharp rally.



Near term Structure
Their are two alternatives:

  1. Bond market has traced out a ABC correction to the upside since early February. Within this correction every wave is sub-divided into 3 waves. However, the sub-component of C-Wave have the following composition (A=5 waves, B=3 waves, C=5 waves). This would mean that we need another decline to complete the long term structure. 
  2. Bond market has just completed a series of 1's and 2's, and will soon start rallying sharply in wave 3 of 3. This wave count is based on the bond market tracing out a series of 5 waves in up moves since Feb 14, and tracing 3-waves during corrections.This alternative is supported by the pessimistic sentiment towards bonds. 




Critical Level:
Bond market should not break below Feb 14 lows to hold the rally assumption.

Sentiment:
The sentiment picture towards Bond's prospects if very grim, which suggests that there is a lot of fuel to propel a bond market rally. One of the biggest argument that we have been listening to in regards with the new Bond Bear Market is related to the concept of "The Great Rotation." According to this argument people will start taking their money out of Bond funds and will put in stock funds, which will result in a decline of the Bonds and rise of the Stocks. However, this argument is not only flawed, it is a great contrarion indicator because when every one accepts a reasoning, it typically fails to materialize. We have discussed Bond market impact in detail in the following post:  

What Great Rotation?


Secondly, recently FED stated in its minutes that they will start debating their QE infinity program. This announcement sent both Bonds and Stocks down. However, this announcement can be taken as a contrarion indicator on the part of the Bond prices. As many investors are assuming that FED's exit from buying bonds will be negatives for the Bond prices and hence selling their positions, this announcement might be a contrary buy signal. We have discussed FED's impact on Bond and Stocks in detail on the blog here:

FED's Minutes: Bonds or Stocks?



The commitment of traders data of the Bond market suggests that Commercial Hedgers (big banks) are net long and Large Investors are very short. The Large investors have historically been wrong about the market's direction. Therefore, this is another catalyst t propel the Bond market rally.

Finally, Bond sentiment as measured by several sentiment measures is at multi-year low, with a composite measure of surveys recording among the lowest bullish opinion in a decade. This observation is again very bullish for the Bond market.


Conclusion:
Pessimistic sentiment in the Bond market supports the Bullish argument. Therefore, we should be vigilant of a new bond rally, with pre-defined risk above the critical level.



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Sunday, February 24, 2013

Bond Price Relationship

This is the 2nd post on this Topic. First post gives a background about Bonds and their pricing strategies. It can be read here.


Reasons for Bond Price rise (Both of these reasons are valid for the US Bond Bull market): 
  • Prices will rise if interest rates go down e.g. Federal Reserves lowers the interest rate or we have deflationary pressures.
  • Prices will rise if there is extra demand (supply/demand curve -  Higher Demand = Higher Price). This typically happens under two scenarios: 1- Economy is doing well, and people feel that they will get the returns promised by the country. As a result, they buy bonds as investment (Economic Confidence Trade). 2- Everything else is doing so bad that investors don't have any choice but to buy bonds (Fear/Safety/Risk off Trade).
These reasons can be inverted to suggest why Bond Prices Fall:
  • Prices will decline if interest rates go up e.g. Federal Reserves increases the interest rate or there are inflationary pressures in the market. Inflation typically happens in a good/robust economy (not always).
  • Prices will decline if there is lesser demand (Supply/Demand curve -  Lower Demand = Lower Price). This typically happens under two scenarios: 1- Economy is doing very poorly, and people feel that they will not get their money back from the country. As a result, they will dump their bonds (This was seen in Europe in 2012, where the Bond prices fell along with the Stock Market, and the yields reached 6% for some countries, which had to seek bailout funds). 2- Everything else (commodities and stocks) are doing so good that investors don't have any choice but to sell bonds (Rotation/Risk on trade).
Based on the above mentioned explanation, lets analyze the U.S. Bond market. 

US Bond market has been going up because U.S. Bonds were considered safe haven during the financial crisis of 2008 and during the 2012 European crisis. This situation was further amplified by Federal Reserves extra low interest rate policy, and the subsequent QEs. Finally, there is a 30 year cycle in the Bond Markets. This cycle bottomed in 1980 and will be topping out soon. All of the above reasons have contributed towards a Bond Market's Bull run. 

Bond's Relationship to Stocks:
Some argue that when Bonds go up Stocks go down (inverse relationship) because investors (small and large) shift their investments from bonds to stocks (Rotation / Risk on trade). This is the same argument that is being given right now in the form of "The Great Rotation." According to this thesis people will sell their bonds, and will put money into the stocks.

However, the inverse relationship is not true in the long term. For example Bond Bull is started in 1980, but during this time we have seen a secular Stock Bull Market (1982 to 2000) and are now witnessing a secular Stock Bear Market for the last 13 years (2000 to Present). As mentioned above, it is also possible for stocks to decline in sync with bonds. This will happen when people lose confidence in the government (recent European Example). 

Current Situation:
Commodity markets' price action is suggesting Deflationary pressures are coming back. Deflation means bad economy and lower yields due to both poor economy (safe heaven trade) and low inflation rate. Lower yields result in higher bond prices. This would negate the concept of "The Great Rotation."  In fact, this might suggest that stocks might soon experience a decline. For all those who have been patiently waiting to short bonds: That time will come (probably within 1-2 years), but it seems like its not now!!

Friday, February 22, 2013

Bonds: Price vs Yields

This post and the next post will be dedicated to a question that was asked yesterday on the blog regarding Bond market's bubble speculations. I will try to address the question in the following format:

1- Question
2- Define Bonds
3- Mathematical definition
4- When/why Bond prices rise or fall?
5- U.S. Bond market
6- Relationship of U.S. bond market and U.S. stock market
7- Conclusion

Question:
"I still don't get it. I've seen and heard that bonds are getting bubbly. So, if they explode, are interest rates going up down? and stocks go up?"

What is a Bond:
In finance, a bond is an instrument of indebtedness of the bond issuer to the holders. It is a debt security, under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest (the coupon) and/or to repay the principal at a later date, termed the maturity.Interest is usually payable at fixed intervals (semiannual, annual, sometimes monthly). 
Thus a bond is a form of loan: The holder of the bond is the lender (creditor), the issuer of the bond is the borrower (debtor), and the coupon is the interest. Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure. 
Bonds and stocks are both securities, but the major difference between the two is that (capital) stockholders have an equity stake in the company (i.e. they are owners), whereas bondholders have a creditor stake in the company (i.e. they are lenders). As a result, if a company goes bankrupt creditors are repaid first and then owners are paid.

Pricing Formula:
Below is the formula for calculating bond's price, which uses the basic present value formula for a given discount (interest/yield) rate: 
P = (C/ 1+i   +   C/(1+i)^2    +   .....    +   C/(1+i)^n) + M/(1+i)^n
where:
F = face value
iF = contractual interest rate
C = F * iF = coupon payment (periodic interest payment)
n = number of payments
i = market interest rate, or required yield
M = value at maturity (usually equals face value)
P = market price of bond.

To summarize: 
  • Price of Bond is inversely related to the yield: Prices go down as interest rates go up
  • This inverse relationship is true for all Bond, Government or Private
In the next update, I will present various reasons why Bond Market acts can differently under different circumstances. It will also summarize the Bond market discussion in regards with current market action.

If anyone wants a similar explanation on any other topic, please leave a comment, and I will try to address it on the blog (if time permits).


Thursday, February 21, 2013

FED's Minutes: Bonds or Stocks?

Although today's market decline was triggered by the FED's meeting minutes, they coincided perfectly with the IPM Model's prediction for an upcoming bottom in the next few weeks.

Meeting minutes showed that FED will start debating the end of QE (Quantitative Easing) in March. This is a big announcement, especially when every one was assuming that QE will continue forever. In other words, we are in QE Infinity. Based on this thesis many fund managers declared a long lasting Bull Market and went all in.

One such extreme measure of sentiment was seen in the Naaim Survey of Wealth Managers. It showed that 50% of fund managers were 100% invested into the stock market last. Their average exposure was at 90+%. This is one of the highest reading I have seen in this survey. Although a Bull Market needs bulls, it cannot continue its rise when all the buyers have already bought in. Because at that point, only sellers remain in the market. This can setup a dangerous decline for the market.

From a fundamental perspective, FED's minutes have wide ranging implications for both the Bond and the Stock Markets.

Bonds
Some analysts would argue that FED was the biggest buyers of bonds, and it was because of FED that the yields were so low. In fact, one of the goals of the QE policy was to bring down the yields so that investors and individuals can buy houses at an affordable interest rate. Therefore, if FED decides to end its QE policy, it would cause a decline in bond prices, which would cause interest rate spike. Spiking interest rates will be very detrimental for a fragile economic recovery, which is already being affected by year end payroll tax increase & the potential Sequestration cuts. In short, QE policy review will be bad for the Bond market.

Stocks
Other analysts would argue that Stocks were rising because of the QE money printing by the FED. This policy provided additional liquidity in the market, which caused commodities and stocks to rise due to the reflation theme. However, if FED takes away its stimulus, it might bring back the specter of deflation to the forefront. Deflation is the worst enemy of Stocks and commodities.

Commodity complex is already showing a very gloomy picture with Copper, Gold and other precious metals declining sharply over the last week. This suggests that Deflationary pressures have again taken hold, and could result in further stock market decline.

To summarize, FED's decision will impact both bonds and stocks. It is clear that since we are not in a robust economic recovery, any withdrawal of easy monetary policy will bring back the fear of Deflation. Deflation will result in Stock Market decline, along with a decline in the interest rates. Hence, even if QE ends, bonds might rise sharply. But this time the rise will be due to bad economic conditions, and not due to FED's Bond buying program.

Above is the fundamental argument in favor of the Bond market, in light of FED's meeting minutes. In the next update, we will discuss the technical and sentiment picture of the bond market which favors a start of new rally for the bond market.

Tuesday, February 19, 2013

What Great Rotation?

Over the past few weeks, we have been hearing a lot about the concept of "The Great Rotation." Its theme revolves around the fact that investors who have been putting money into the bond fund for the last decade will now start to rotate that money into the U.S. stocks funds. This rotation will create significant buying pressure in stocks, pushing the market to all time new highs.

However, there are several flaws in this argument.

First: In order to reach price equilibrium market requires buyers and sellers. If significant number of U.S. bond investors decide to sell their bonds, we will need enough investors to buy this supply. Otherwise, bond prices will crash. If bond prices crash, yields will rise sharply. This will very negatively impact the U.S. economic growth, as businesses and individuals will not be able to purchase properties and/or big ticket items on lower interest rates.

Furthermore, once interest rates significantly increase above stock market dividend returns, they will force prudent investors to seek higher returns in the less volatile Bond market. This would also put a burden on the upward rising trajectory of the stock market, and will provide a support for the Bond prices.

Second: In order to justify higher yield, we need the economy to grow at a faster pace. This rise will trigger inflation concerns, and will force the FED to increase interest rates, which will in turn result in bond price decline. But please keep in mind that the economy is not robust yet, even after years of extraordinarily easy monetary policy by the FED. And with recent payroll tax increase & Sequestration cuts, U.S. economy will not become robust for the foreseeable future. Therefore, it is hard to imagine Bond yields rising sharply.

Third: According to a recent survey individual investors are currently almost 65% invested in the stock market. This number is in line with historical averages, suggesting that investors are not substantially under invested in stocks right now. Therefore, they cannot really reallocate into stocks if they are already in stocks.

Based on the above reasons, the Great Rotation argument does not posses merit.

At the same time, historically when individual investors have started putting money into stock funds in droves (as they have done in January and February), it has been a good time to exit the market. We have not only seen this behavior before stock market tops in 2010, 2011 and 2012, but also in the 1980s. Individual investors started to put money back into the stock market in the 2nd quarter of 1987 but the market topped out in the 3rd Quarter of 1987, just before crashing in October 1987.

Therefore, if history is any guide, one should be worried not happy about recent pessimistic sentiment towards bonds and News Headlines about the Great Rotation. In the next update, we will analyze the bond market from a structural and sentiment point of views.

Saturday, February 16, 2013

Market Structure: Then and Now

Over the last 3 weeks market has gone net sideways. Some have gone up, while others have gone down. As chatter for correction grew louder, market managed to disappoint many participants by going sideways. Most interesting observation is that market managed to stay elevated in the face of Sequestration uncertainty.  Sequestration are the automatic spending cuts scheduled to take effect on March 1, 2012, if Congress fails to take any action. At this point in time with Congress not willing to compromise on tax increases and/or entitlement cuts, Sequestration seems very likely. This will be a big blow to the economy.

At the same time, all of us working individuals felt the impact of payroll tax increase in January. However, its real impact is becoming apparent as retail stores are showing worsening sales. For example, Wal-Mart's numbers for February are the worst in ~7 years. If Wal-Mart is doing bad, others must be worse. This could result in reduced GDP for Q1 2013.

If one combines this spending reduction with potential Sequestration cuts and the associated job losses, it could be the perfect recipe for a negative GDP quarter. Since Q4-2012 was also negative, another negative quarter will put USA back into recession.

After laying out a very possible gloomy scenario, lets review what market trajectory was predicted in the IPM Model Report and what really happened, in face of such uncertainty.


Above chart is an excerpt of the IPM Model library sent to subscribers on February 1, 2013. At that time, UST expected that the market will go sideways to up before bottoming out at the next IPM turn date. This observation was also mentioned on the blog on January 29, 2013:
"In other words, market will continue to go sideways/down till the next IPM Turn window"

Since IPM Model Top Date of Jan 28, 2013, US/Global markets' performance is shown below:

Market
Jan 28 High
Feb 15 Low
Performance
DJIA
13916
13906
0%
SP500
1503
1514
1%
Nasdaq
3162
3184
1%
GDOW
2118
2095
-1%
Europe ETF
35
34
-3%
Italy
14.63
13.13
-10%
Germany
7872
7588
-4%


In short, pretty much all the markets have gone down/sideways after topping on January 28, 2013. It was the same time when most of UST Subscribers exited the market based on the IPM Model top date. 

As of today, US markets are on the verge of a significant decline. It can take place at any time. But we must keep in mind that IPM Model turn window is also fast approaching, so the decline might be short but sharp. After this decline, we could see another rally in the global markets. For this rally, emerging markets will be best positioned as they have seen significant correction since January. Whereas US markets might not rally that sharply because of excessive optimism and lack of deeper correction.

US Treasury bonds are also setting up for a sharp short-term rally, if they can hold above recent lows. A rally in the T-Bonds will put downward pressure on the US indices for a deeper correction.

To summarize, it feels very good to be out of a choppy market while others are getting chopped up in the daily gyrations and to get ready to buy back near the upcoming IPM Model Bottom date. I would like to Thank God for this blessing



Sunday, February 3, 2013

IPM Model Update

IPM Model Update has been e-mailed to subscribers.

Update 2/4/13
Weekly IPM Model update (Special Report) has been e-mailed to subscribers. Weekly IPM Model output could have far-reaching impacts on the overall market.


Weekly IPM Model: 

Daily IPM Model generates turn dates which occur every 1-2 months because the data frequency is higher. Keeping this observation in mind, Weekly IPM Model will generate turn dates occurring every 4-5 months because the data frequency is low. However, these turn dates are often more significant than daily turn dates. 



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