Betting Against the Bond-Bull Connection

SAN FRANCISCO -- The perception among many traders is that the bond market's tumble since Nov. 8 is a harbinger of economic recovery, which is bullish for equities. Such sentiments were on display again today as stocks and bonds took divergent paths once again.

The Dow Jones Industrial Average rose 0.8%, the S&P 500 gained 1% and the Nasdaq Composite climbed 1.8% today, aided by a smattering of takeovers -- Immunex (IMNX), Security Capital (SCZ), USA Networks (USAI) and Anchor Gaming (SLOT) rising on respective M&A developments. But stocks failed to sustain intraday highs, retreating as the bond market mounted a remarkable turnaround from early losses. After rising as high as 5.40% intraday, the yield on the benchmark 10-year Treasury note closed at 5.18%, its price rising 1/32 to 98 20/32.

Early on, the bond market's renewed selling provided the foundation for many participants' renewed sense of optimism.

"Unless the Treasury market collapses, I still think this steady, orderly decline in bond prices and higher interest rates portends good things for GDP growth and thus the U.S. stock market," commented Brian Gilmartin of Trinity Asset Management in Chicago.

Gilmartin, who runs about $20 million, probably isn't alone in thinking the bond market getting "whacked" is a "good thing" for stocks.

Ironically, the bond market's rally in the first week of November -- after the announcement of the elimination of the 30-year -- was also declared as bullish for stocks for valuation reasons. Such arguments have largely been forgotten -- or glossed over -- and the equity bulls have been able to have their bond market cake, eat it, too, and lick the bowl.

Not all traders buy the argument. What's transpired "represents another opportunity for investors to reposition," said Donald Coxe, chairman and chief strategist at Harris Investment Management in Chicago, which has more than $17 billion under management.

Among myriad theories -- year-end selling, selling by mortgage-backed market participants and/or foreigners -- Coxe surmised the bond market has acted so poorly of late because asset allocators who "guessed wrong" about financial markets after Sept. 11 are now "frantically buying equity index futures and selling T-bond futures and other debt instruments."

But the strategist believes speculators will be proved wrong again because of the combination of the heavy debt burden of U.S. corporations and consumers and the deflationary implications of China becoming "more of a price setter" in the global marketplace. (Edward Yardeni, chief economist at Deutsche Bank, made a similar observation today, which was duly noted by the still-bullish Don Hays of Hays Advisory, and so on and so on...)

To Coxe, the implication is that "this recovery is going to be a lot slower than the market is telling us" and that investors should "get as long as you can in the bond market," meaning long-dated Treasury securities. "I'm stunned by the view taken by stock and bond markets that we're going to have a roaring V-shaped recovery," he said.

The current trend of the bond market collapsing while the stock market rallies amid a "dubious economy," makes sense near term because of the liquidity being pumped into the market by the Federal Reserve, Coxe said. "It probably [also] indicates that investors have more money than brains."

Same Outlook, More Diplomacy

Brett Gallagher, who oversees about $3.5 billion as head of U.S. equities at Julius Baer Asset Management, expressed a similar, albeit less condescending, view.

Lost in the rejoicing about the presumed economic implications of higher bond rates is that "nobody is factoring in the effect higher rates are going to have on the valuation of the equity market or the toning down of mortgage refinancing," Gallagher said. "The rise in interest rates we're seeing is going to end up short-circuiting the economic recovery."

Gallagher expects the economy will recover next year, but not as robustly as many on Wall Street currently expect because consumers' "gas tank is getting close to empty." A combination of the reversal of the so-called wealth effect, the end of the refinancing boom, rising unemployment, falling savings rates and high debt levels will result in a curtailment of consumer spending in the months ahead, he suggested.

On top of higher costs for insurance and security, it means "not much of an earnings recovery" for corporate America, Gallagher forecast.

Given that outlook, Julius Baer has recently been raising cash to about 10% after it had gotten to as low as 2% of assets last month. "We participated in the run and are probably leaving the party early, but I want to be positioned [for 2002] in the way that makes the most sense, which is more defensively," Gallagher said, reiterating a fair value estimate of 880 for the S&P 500. For year-end 2002, he surmised fair value for the S&P 500 of 930; "whether we get there or not is another question, but I do think gravity [will] pull the market in that direction."

Julius Baer has recently exited long positions in EMC (EMC), Sun Microsystems (SUNW), Veritas Software (VRTS), KLA-Tencor (KLAC), the Nasdaq 100 Trust (QQQ), as well as J.P. Morgan Chase (JPM), due to lingering concerns about its exposure to Enron (ENE) and derivatives in general.

"I would be very surprised if Enron ended where it was and nothing additional reared its head," Gallagher said, predicting the bankruptcy workout is going to be more difficult than the participants are suggesting. "Rather than buy into everything [J.P. Morgan] is saying, we believe the better course is to reduce exposure."

Julius Baer maintains a stake in Enron's other big backer, Citigroup (C). Gallagher believes Citigroup has more areas to offset any additional hit from the erstwhile energy-trading giant, which "has tentacles that are going to show up in places we hadn't expected."

That said, Gallagher is considering using some of the fund's recently accumulated cash to increase existing positions in El Paso (EPG), which has been whipsawed by the Enron situation, as well as Anadarko Petroleum (APC).

Through Nov. 30, Julius Baer's U.S. equity portfolio was down 6.52% vs. a decline of 12.6% for the S&P 500.

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