(Editor's note: This is an excerpt from Hedgeye's "Investing Ideas" from this past weekend. This particular research product is designed for the savvy, longer-term self directed investor looking for fresh, exciting long-only opportunities. With your subscription, you'll know immediately when one of our award-winning analysts uncovers a new Idea or changes a current one.)
HOW MUCH IS “TOO MUCH”?
The US bond market is at an all-time high, with $38 trillion of US bonds outstanding. Nearly a quarter of that – $11 trillion – is US Treasury debt, and another $8 trillion is mortgage related. And note that the latest abdication of duty by the nation’s bank regulators – described in the previous section – will add significantly to the mortgage-related number. The relaxing of lending standards is allegedly aimed at stimulating housing. But Hedegeye’s work has shown that the housing sector hasn’t needed government stimulus for almost a year. In fact, if the government were to butt out, the housing sector would recover on its own timetable, in concert with other improving demographic measures such as new family formation, rising birth trends, and improving employment. Here you see a perfect example of how government meddling is guaranteed to create a bubble in an already over-inflated bond market.
Adding fuel to this particular conflagration, the major brokerage firms have trimmed their fixed-income books, trying to get out of the way of the proverbial falling knife. This means there is shrinking liquidity in a market that has gotten way too big already. This will increase volatility, and will force bond prices still lower. Oh, and it’s decidedly bad news for those investors (presumably mostly foreign pension managers and insurance companies) who will buy the soon-to-be-issued new mortgage paper that will be generated now that the banks don’t have to have skin in the game.
Casteleyn says the bond market represents 2/3 of the securities market, meaning there are two dollars in bonds for every dollar of stock – even after the equities market has risen 100% in the last 4 years! This skewed relationship is unwinding, triggered by the Fed initiating its Quantitative Easing program in 2008. The start of QE caused a number of market dislocations. By taking a large portion of the apparent risk out of the fixed income market, it drove down the premium that corporate bond yields had traditionally offered over Treasuries, and even resulted in yields on junk bonds coming down heavily to what were historically considered low-investment-grade levels.
Most obviously, QE forced investors to seek out riskier assets in their desperate quest for return, with the result that the stock market roared back from its post-Crisis lows. This appears to have been Bernanke’s straightforward objective, and he has certainly achieved it. Casteleyn’s analysis makes it clear that the “Bernanke glow” is just the beginning of a bull market in equities that could be every bit as massive as the 30-year bull market in bonds that has now ended.
Casteleyn says money is flowing out of the fixed income market, and into equities, at rates not seen since before the financial crisis. Last week alone investors withdrew $11.1 billion from fixed income mutual funds. Equity funds continue seeing their first positive year since 2007, with inflows at $1.3 billion for the week, resulting in the first annual inflow into stocks in over 5 years.
For those who are afraid they “missed the move,” there remains more than $2.6 trillion of investible capital in money market funds, although with the expectation that money funds are never drawn down to zero, investors will have to make allocation decisions between stocks and bonds. Casteleyn says pensions have historically low allocations to stocks and record high exposure to fixed income – which means that as the bond market continues to kick off losses, fixed income will continued to be sold to reallocate into equities.
Casteleyn points out that the current setup of this rotation from bonds into equities is following its historical cycle. This means that the bulk of the rotation is winding up in money market funds before the eventual re-planting into the new asset class. Thus the carnage in fixed income currently is largely landing in money funds before the eventual reallocation to equities. Still, even while waiting for investors to take the plunge, we have seen the initial signs of inflows into stock funds this year for the first time in 5 years. Inflows into equity funds are averaging $2.7 billion a week this year, a reversal from the $3 billion weekly outflowsin 2012.
Of all the not-so-unintended consequences of the Fed’s program to promote risk-seeking behavior, one actually not intended consequence could be overstuffing money market funds to a point where the funds buy increasing quantities of risky paper. This has happened before – writing in February of 2012 in the Wall Street Journal, Sallie Krawcheck, former president of the Global Wealth & Investment Management division of Banc of America warned about the lack of transparency of the funds, as well as the decidedly dicey composition of their portfolios. You may be aware that the SEC has introduced a rule requiring certain classes of institutional money market funds to post an actual net asset value, and not an artificial $1 price. What you may not know is that for many years, as more and more money flowed into money market funds, managers went further afield in their hunt for yield – including buying bonds in such places as France, Italy and Spain – and Greece – in the midst of the Financial Crisis.
Heard enough? The good news is: you haven’t missed the next big up-move in equities. The scary good news is, this bull market in equities may run much farther, and last much longer than many people anticipate. Keep your eye on Hedgeye – we’re keeping our eye out for you.