The Daily Decision for 2.9.18 - Is This Really About Rates?

The State of the Markets:

I usually don't write on Friday mornings. However, with the Dow experiencing its second quadruple-digit dance to the downside of the week yesterday, I figured it was probably time to make an exception.

The goal of this morning's hopefully not-so meandering market missive is to try and answer the key question of the day. As in, what the heck is going on here?

Okay, let's dive in and try to make some sense of yesterday's trash-job in the stock market. Cutting to the chase, the narrative seems to be that once you get past the high-speed algorithmic trading (those robos DO love following their trends on a millisecond basis!), the forced selling (can you say, "margin call?"), and the deleveraging that is likely occurring in hedgie-land (hey guys, maybe this isn't the time to have the pedal to the metal anymore, right?), the focus lands squarely on interest rates.

The Story of Rates - A Two Parter

In my opinion, there are really two parts to the rate story. First, there is the level of rates. And then there is the speed at which rates are rising.

The market can probably handle the first part. However, the second part means that something is changing and adjustments are being made - and being made quickly.

Lest we forget, bond yields have been rising for a while now. In other words, the rate move didn't start happening last week. The breakout that seems to be attracting everyone's attention began on December 19, 2017. And since that time, the yield on the U.S. 10-Year has risen from 2.39% to 2.85%. That's a pretty steep climb. And some will even argue that this move, like the stock market before it, has "gone parabolic."

One of the keys here is that along the way, the move in rates has broken some very long and very important trendlines, in pretty convincing fashion.

First, there is the downtrend on the weekly chart of 10-Year yields going back to the end of 2013. This four-year old trend was snapped when yields first broke through the 2.5% mark in the first week of January.

U.S. 10-Year Treasury Yield - Weekly

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As you can see, this trendline has been broken with a vengeance.

Next is the downtrend line on the monthly chart going back to 1994.

U.S. 10-Year Treasury Yield - Monthly

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While I can argue that a sustained break above 3% on the monthly chart would be more important from a technical perspective than a trendline break, I think it is safe to say that the breaking of a trend that is more than 23 years old might be significant.

Wait... Rates Rose When Stocks Tanked?

Getting back to yesterday's action, it is certainly odd that the yield on the 10-year rose while stocks were tanking. And this is part of the point - this doesn't usually happen. Sure, the yield pulled back from the highs as a modest flight-to-quality move occurred in response to the stock market's renewed upheaval. But the fact that bond yields rose yesterday morning is important.

The move appeared to be driven by the combination of (a) the new bi-partisan budget deal, which was struck in order to avoid another government shut-down and (b) some hawkish words from the Bank of England's Mark Carney.

Analysts point to the fact that the new budget deal increases spending by about $320 billion as a reason to fear higher rates. The bottom line is the U.S. Treasury is going to have to borrow even more money than had been anticipated. And given that the Fed is no longer buying anything and everything on the market, traders suggest that this, when added to the supply needed to cover tax reform, means rates are heading up - and fast.

The latter issue with the bond market - the one originating from across the pond - is also purported to be a problem. The Bank of England's Mark Carney said yesterday that his group may need to raise rates sooner than they had previously expected. This took the markets by surprise. And as everyone knows, markets don't like surprises.

Seismic Shift?

The bigger point here is that the global QE era is likely winding down. In short, this means that at some point, there won't be indiscriminate buyers of bonds without regard to price in the global bond markets anymore. And this represents what is being called a seismic shift in the landscape.

And what do you think this means for rates? Oh, that's right, they are expected to go higher - and sooner than folks were expecting.

Can You Say Multiple Contraction?

What does this have to do with the price of tea in China, err, the stock market, you ask? Aren't rates still low enough so as to not be serious competition to the market? And aren't rates also still low enough for economic and earnings growth to continue?

While I can argue that the answer to both questions posed is yes, it is important to remember that the multiple investors are willing to pay for a dollar of earnings changes as interest rates rise. And while this may sound a bit far-fetched, analyst Art Hogan reminds us that back when 10-Year yields were in the 5% zone, the average P/E for the S&P 500 was around 15.5, not the 18 seen today.

Do I "really" think that the S&P is experiencing "multiple contraction" this week? Uh, no. However, this type of thinking could certainly keep buyers on the sidelines longer than they might have been when rates weren't rising as fast as they are now.

In closing, let me say that rising rates is a fundamental issue that investors may be starting to grapple with. However, the bigger issue from a short-term perspective is the technical action, which hasn't been pretty at all. But then again, things can change quickly in this game and there are some pretty big inflation reports on the calendar for next week, which, of course, could certainly impact rates.

For now though, we need to get to next week's data. Here's hoping that some calm returns to the corner of Broad and Wall (oops, I mean the server farm in Mahwah, New Jersey) at some point soon.

Thought For The Day:

In the course of my life, I have often had to eat my words, and I must confess that I have always found it a wholesome diet. -Winston Churchill

Wishing you green screens and all the best for a great day,

David D. Moenning
Founder, Chief Investment Officer
Heritage Capital Research
Serving Financial Advisors since 1989
Serving individual investors since 1980
Questions, comments, or ideas? Contact Us

Disclosure: At the time of publication, Mr. Moenning held long positions in the following securities mentioned: None

Note that positions may change at any time.

Today's Model Review:

LEADERS Model: The LEADERS currently holds 20% positions in the Technology, Industrials, Health Care, and Materials sectors - and 20% in Cash. Stay tuned for changes on Monday.

CORE Model (Risk Managed Exposure):
Today's CORE model's exposure target: 30%
Current CORE Model exposure: 50%

To review, the goal of this model is to stay in tune with the overall risk/reward environment. Therefore, we make adjustments only when there is a meaningful and sustained divergence between the target model reading and our current positions.

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2018 YTD Performance Update:
DD CORE: -1.6%
S&P 500: -3.5%

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Current Portfolio Summary

% of
Technology Select Sector SPDR XLK 20% 12.1.16 $46.64 Buy
Industrial Select Sector SPDR XLI 20% 8.14.17 $68.58 Buy
Health Care Select Sector SPDR XLV 20% 11.27.17 $81.79 Buy
Materials Select Sector SPDR XLB 20% 1.16.18 $63.02 Hold
Cash Cash 20% 1.16.18 $1.00 Hold

% of
ProShares UltraPro S&P (3X) UPRO 16.67%
(Equiv 50% Long)
Various $98.78 Buy

% of
iShares Eurozone ETF EZU 20% 5.11.17 $40.25 Buy
iShares Emerging Markets ETF EEM 20% 6.112.17 $41.57 Strong Buy
VanEck Vectors India Small-Cap Index ETF SCIF 20% 7.18.17 $58.00 Buy
iShares Russell 2000 ETF IWM 20% 10.19.17 $146.09 Hold
ETFMG Alternative Harvest ETF MJX 20% 1.30.18 $35.29 Buy

% of Model Explained

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The Daily Decision is designed to be a simple, easy-to-follow e-letter service showcasing 3 different model portfolios. The LEADERS model is the flagship, growth oriented strategy that focuses on "where the action is" in terms of market leadership. The CORE model is a longer-term, risk-managed approach to keeping exposure to market risk in line with prevailing conditions. And as the name implies, the TRADING model is intended to be a tactical, opportunistic trading strategy.

Disclosure: At the time of publication, Mr. Moenning held long positions in the following securities mentioned: All. Note that positions may change at any time.

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The Front Range Trading Team

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Posted to Daily Decisions Service on Feb 09, 2018 — 9:02 AM
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