The Bond Market: The Tail That Wags The Dog
In early June 2002, Tony Crescenzi chatted with Eddie Kwong about the current state of the markets and the economy. The theme that came out of the conversation will be thought-provoking for all stock traders. That is that the bond market is a powerful leading indicator for the stock market that is all too often ignored. In this interview, Tony will explain how to anticipate long-term trends in the stock market by interpreting action in the bond market. He will also tell you about his new book, The Strategic BondInvestor. One additional note from Eddie: At various points in the following transcript, Tony and I discuss news and market action in real time as it unfolds during the interview. From time to time there are off-topic comments have not been edited out in order to give you some insight on how Tony interprets news.
The Outlook For 2002And Beyond
Eddie Kwong: Tony, what’s your big-picture assessment of where we are right now, both in the economy and the stock market, since Sept. 11?
Tony Crescenzi: Well, I think we have two major forces shaping the economy and another major force shaping the action in the equity markets. In the economy, we have both cyclical and secular forces helping to lift economic growth. On the cyclical front, we have very low inventories. Inventories year-over-year are at the lowest level in decades. Low levels of inventory are forcing businesses to raise production, and we’ve seen production rise each month this year. And as production rises, so do incomes because people work longer hours and workers get added. As they earn extra income, of course they spend more, and extra spending results in more production. And hence, income and spending and production. That’s how you get to a virtuous cycle of economic growth. So the inventory story is very beneficial right now.
Kwong: We’ve got quite a nice short-term pop going on…
Crescenzi: Well, what Putin said about the India/Pakistan conflict is quite a positive comment… plus the VIX, which I see Larry Connors had a very nice article in Futures magazine, I just looked at it today. The VIX was very high, I think the highest since early February, and I think that was a signal for the markets…
Kwong: Yes, he made that statement last week in the Wall Street Journal, too.
Crescenzi: Yeah, that’s right. It really is a great indicator. So back to the economy. We see inventory is likely to benefit the economy for at least a few more quarters. So that’s the main cyclical force right now. The main secular force driving the economy is the growth in US productivity. We see growth for the last two quarters averaging about 7%, and as productivity advances, historically, it’s correlated with growth in profits.
Kwong:What does that tell you, based on history?
Crescenzi: If you look at charts going way back, you see profits and productivity growth overlapping each other, really moving in lockstep. So a strong growth in productivity should help profits — in the long run intense income growth, and hence, the overall economy. So there are very good secular and cyclical forces right now. Plus, the weaker dollar could have a positive influence on profits going forward. A 1% drop in the value of the dollar equals a 1% increase in profits for manufacturers. That’s good news for a big part of our economy.
The Next Bull…How Long Do We Have To Wait?
Kwong: What is the typical time frame in which we can begin to see the effect of this inventory boost in the stock market? Everybody is staring at the charts and generally they’re seeing red.
Crescenzi: It’s had the impact on the economy, and of course typically, the stock market seems to move in advance of these things, but these days the problem with equities is that they are being frowned upon as an asset class simply because people are disenchanted, disillusioned because of major events such as the busted bubble, 9/11, Enron, accounting concerns, now the Middle East — worried about a lot of things. But in the long run, of course, people will tell you that as long as profits keep advancing in the long run, the stock market’s gains should be consistent with the gains in profits.
Kwong:There seems to be a disconnect or delayed-effect because the low inventories, increased production, and extra income for workers doesn’t seem to be kicking into the stock market yet.
Crescenzi: It’s just that right now you’ve got households liquidating assets. We see household holdings of stocks down to under 40% of the market cap. It was at over 50% a couple of years ago, so households have liquidated to a very large extent. They’re probably running out of room and getting under-exposed. So typically we should have seen a response in equities already. It’s just that households are liquidating stocks because they’re disillusioned. But in the end, it may turn out that they’ve oversold and have become under-invested in the market, and ultimately that will fuel an advancement. What that will be, it’s hard to see, it’s an emotional issue. The economics certainly have been very good. There’s very little wrong with the economy right now.
Kwong: Interesting.That’s an opinion I don’t hear much these days.
Crescenzi: It’s all moving in a way that should restore profitability for companies and in the next — for the rest of the year, we should see the numbers for corporate profits begin to turn. We’ve had six quarters in a row with profits down, but it’s looking like the estimates are for the rest of the year to see double-digit growth. That should propel equities.
At some point, if people have reasons to be confident — there has to be a catalyst, though, maybe some type of peace between India and Pakistan — after all, fear of fallout from nuclear bombs caught between those two countries is a valid concern. The problem is for everyone. And similarly, these warnings over these potential terrorist acts that we heard from the Government a few weeks ago are still being digested by individuals. Once a period of calm passes, God willing, I think we’ll begin to see the markets begin to behave in the way they did before they began to decline in March. We have to remember the recent decline began when the Israelis moved into the West Bank. So I think there’s a connection there between tensions in the Middle East and equity market performances.
Foreign Money Exodus Still a Concern?
Kwong: To what extent does the recent weakness that we have seen in the market have to do with the foreign money coming out of the market? You mentioned this in our previous conversation a few months ago. What’s your take now?
Crescenzi: I have a table to show the levels of investment by foreigners over the last eight years in stocks and corporate bonds to show how enormous it had been.
Right now, I think there’s no question that in 2000, net foreign buying of US equities was about $175 billion. In 2001, it was about $120 billion. In the last 12 months, it’s about $80 billion. So we’ve already seen a net reduction in purchases by foreigners of $100 billion. We know what that feels like. It’s not like we’ve had sharp liquidations from the foreign investor. We have to remember that the same theories about foreign liquidations being tossed around now were being tossed around in 1999 and 2000, before the bubble busted.
People said that when the equity market faltered that people who had invested in mutual funds would liquidate positions in large amounts. It never happened. You didn’t see mass liquidation. That theory was for institutional investors. Here, people are trying to say that institutional investors abroad, and again, most of the net foreign buyers from institutions — people are trying to say that these institutions will be big sellers — but it’s hard to imagine they would be. There are too many reasons to continue investing in the US, particularly our high levels of growth in productivity. That makes for a very good investment environment. We’re still growing. We’re stronger than most of the world. We have low taxes, low regulations — a very good climate for investing.
Kwong: We’re probably best place in the world for their money in the sense of where else are they going to put their money, right?
Crescenzi: Right. Japan? That’s not an option. And even parts of Europe, with an unemployment rate at 9% and a Central Bank there that does not permit growth to exceed the rates of growth that we see here because they are afraid of inflation so much. So I think they will continue to stay with the US market. Of course, they can reduce their investment somewhat. There will be periods where there are bouts of liquidation but not large-scale liquidation…
One important point, from 1985 when the dollar posted its last major high, between 1985 and 1982 when the dollar posted its last major low, the dollar lost 50% of its value. Yet during that period, the S&P gained 115% and with dividends reinvested, it gained 166%, so the dollar can decline and stocks can rally at the same time, again because it’s beneficial to US companies because it makes our goods more attractive to buyers so we are going to sell more goods throughout the world. And that’s good news.
We’ve already seen exports rise five of the last six months, up at a 7% annual rate. The previous twelve months, exports fell 16% in the year prior, so we’re already seeing a positive impact from the dollar having weakened and the increasingly positive impact going forward, so investors should be thinking about buying companies with high levels of export sales or capital goods stocks, for example. Those depressed stocks should benefit from increased sales. Those stocks should benefit from increased sales. Forty-three percent of all US exports are in capital goods. So the Capital Goods sector will improve and, of course, in a bet on the Cap Goods sector, you have to bet that US demand for goods will pick up, and I think with profits likely to pick up with the economy doing well, it’s a fair bet to make right now with prices down.
Kwong: One thing I recall from conversations that you and I had shortly after Sept. 11 was that a large percentage of the gross national product was based on the travel industry and then we saw the impact right off. Have we passed through the riskiest part of that phase?
Crescenzi: Yeah, I think we’ve already seen airline companies hire back a fair number of workers. The industry had lost about 100,000 jobs. They are likely to continue to add workers back. I mean you can see they’re trying to raise prices and having difficulty…an indication that the demand factors are better. It’s just security issues are key.
Kwong: I would imagine it’s a very sensitive sector right now because a lot of things could trigger…
Crescenzi: That’s why they’re weakening again. If you look, there’s been a loss of clients since tensions heated up in the Middle East and with tensions with Pakistan and India, it’s the same thing because people feel that could disrupt the War on Terrorism and therefore hurt the airline stock. But traveling is up, it’s just business travel that’s a bit soft still. It’s an area of good pricing power for the airlines so, like I say, they will continue to have problems for the rest of the year because of security concerns. I think it’s not until the end of the year when certain other security measures get implemented.
Kwong: Then the risk factors of flying decline…
Crescenzi: The new people that are trained, the new equipment that’s supposed to be in place I think by November, to detect bombs. A lot of things that will make people feel more secure won’t be in place until later in the year. So I think these issues will continue. The one good thing is that energy prices have stabilized. Of course, I can see some companies have very high fixed cost and this is one fixed cost that’s very positive.
What The Yield Curve Says About Stocks Now
Kwong: Right now I want to touch on another one of the points you just made last time we talked. We have a yield curve right now which is very favorable to the stock market. In fact, I was looking at it the other day and it is as steep as it was in 1994. We had nice run-up from there.
Crescenzi: That’s right. The yield curve has been steepening. You’re right. It’s the steepest it’s been since 1994. That then was on a declining trend. Let’s go back one more period here. The last pattern in this we saw, it steepened from late 1989 until 1993 and of course that was because the Fed was cutting interest rates during much of that period, and it helped the economy to emerge from recession and eventually enter a period of strong growth. So the basic point is that it’s steep because the Fed is accommodative and… Greenspan’s just made this statement, “This economy is showing resilience in the face of shocks.”
Kwong: Greenspan must have been listening to our conversation.
Crescenzi: He said this recently. It’s interesting. I wonder because of the weakness of stocks if he wants to sound positive today. This is a comment he’s made before. So, yeah, the steepness of the curve suggests the Federal Reserve’s policy stance is designed to aid the economy, and it’s obviously very positive.
Kwong: And you don’t necessarily see a kick to the stock market right away, but from what I’ve seen, even when you look back at different times through history where the yield curve steepens, it was against the backdrop of very, very depressing events in the world, in politics, in the economy throughout the world, yet somehow the economy responded to the favorable environment that the Fed was creating, as did the stock market eventually.
Crescenzi: Well, that’s right. Sorry, hold it.
(Editor’s note: Tony now turns to some further breaking news on Greenspan.)
Greenspan’s now saying, “The US is more sensitive than others to asset changes.” Let’s take that positively. That means he recognizes that the stock market drop is a problem potentially because our economy is more sensitive to it. That’s a positive. It means he is telling us, “We’re going to support the economy because we realize there is a negative influence here because of the recent drop in stocks.” So that’s caused a little uptick in the S&Ps right there…
Just generally, I think this yield curve has been one of the better indicators for decades. The yield curve has been known to predict events as early as six months in advance, whereas the stock market is somewhere around nine to 12 months, although these days I don’t know if they’re predicting anything, it’s just pessimism. But the yield curve started steepening a while ago.
Tony’s New Book
Kwong: I think that one thing that is very important to the average trader/investor is an understanding of the big picture because most people are just focused on their price charts…and they’re reading the newspaper every day and they’re hearing all the horror stories out of the Middle East. I want to talk about what you teach people in your new book. Tell me about it.
Crescenzi: The title is The Strategic BondInvestor. I wrote the book with the idea that other bond books that exist are too technical. That they confuse investors and they are too technical for the average investor, especially those with very little knowledge of the bond market. What I wanted to do was try to write a book that discusses simple things in the bond market that people could understand and use when they make investment decisions, simple things such as: How do you watch the Fed? What’s the best way to keep an eye on the Fed so that you can make decisions about what they might do next? So Fed watching is a key area, and a chapter on the Federal Reserve.
I also talk about the yield curve — and how you can use the yield curve, which has proven to be a better indicator than the stock market and many other key indicators on the economy and the financial markets. How do you use it to predict what’s next? I outlined that because that’s a very fundamental thing I find absent from most bond books. They tell you what it is and they get technical about it but they don’t describe what you can do with it.
And also I lay out in the Appendix, for example, all the major economic indicators released on a monthly basis described, how they are computed, and how they affect the market. I think that’s a very useful tool because we know economic numbers have a big impact on the markets and basically show how interest rates have a very powerful influence on stock prices and on everyone’s personal life, including when an individual household goes to obtain a home mortgage.
Kwong: Now even though your book is called The Strategic Bond Investor, will it be of interest not just to bond traders, but to the average trader like me and other members of our site?
Crescenzi: That’s right, because they can use this information to have a better understanding about how the bond market affects the stock market, how economic news affects the markets, how they can use the information, the market intelligence that you can get in the bond market and the interest rate futures market, how to track bond market sentiment to glean messages which are good for all markets because obviously the bond market has a big impact on the stock market, so movement in bonds is instrumental to movement in stocks.
One should have an understanding of what moves the bond market and why it’s moving so they can understand what might be next for stocks because to me, the bond market is the tail that wags the dog when it comes to economic performance. Interest rate levels are key to economic performance. Economic performance is key to stock prices.
Kwong: That statement you made has a lot of impact. I think I’ll use “tail that wags the dog” as the title of this interview. Thanks, Tony.
Crescenzi: Thanks, Eddie.