Thursday, January 10, 2013

When You Know The Game Is Over


There are times when it's not worth even arguing. Instead, you just point to the obvious elephant in the room...




This chart goes without saying what cheap money does for the stock market. The white line is the S&P 500 Index / 10 year US Treasury yield (using TNX) ratio. The blue line is the S&P 500 Index itself. This chart dates back to 1968. It goes without saying that since the last market crash, this entire bull market has been off the back of cheap and easy money and nothing more. 

In reality, this has been taking place since the tech bubble collapse in which in real price terms (meaning adjusted for inflation) the S&P 500 made an all time high of 2048. But not until recently have we seen the 10 year yield and the S&P 500 move so far apart, forcing this ratio to insanely high levels versus the S&P 500.

And make no mistake about it, if you believe yields are going higher because of economic growth, you are dead wrong. Due to the debt load we bare and what we are paying in interest on that debt, at no point can we allow yields to rise. They must be suppressed. That is, until outside forces take hold and force yields higher regardless of what the Fed or the Treasury does.

The first chart below is interest expense of the debt outstanding. According to the Treasury, the Department of Defense changed their accounting method (go figure) which dropped the interest expense by $75 billion in July. Without this, the interest expense would have totaled $434 billion with interest rates at all time lows in 2012.




This chart is the total revenue the US Federal Government takes in:



Based on current government revenue and the current interest expense on outstanding debt, we are paying $0.135 in interest expense for every $1 of federal government revenue. I think it goes without saying that out federal debt continues to rise and should rates rise along with our current and future debt load, at some point the fun is up and the game is over. 

I don't know when this ends. I am NOT trading it right now. This is an observation and should be noted. I have said that in the next 5 years, I expect both yields to rise and equity prices to fall. And at some point, fighting the Fed will equal selling the rips. 

In due time...

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UPDATE: June 1, 2013


Here is an updated chart of the SPX/TNX ratio - is the ratio about to break down? Remember, a collapse of the ratio means 1 of 3 events occur: 

1. Yields rise extremely fast while equities move higher/ stagnant
2. Equity prices collapse as yields drop/ hold steady
3. Equity prices drop and bond yields rise (both bad events in 1 and 2)




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UPDATE: July 5, 2013



In one month we have seen quite a turn in the $SPX / $TNX ratio driven by much higher yields (as shown below):

  
The question becomes, how sustainable is higher yields in a slow/ no growth economy? If people are barely borrowing now, what makes them borrow at higher rates? On top of that, do these higher rates benefit or drag down asset prices (eg. homes)? 

We still are a long distances away from returning to any sense of normal in this ratio. Will it be rates that continue to move higher along with equity prices? A collapse in equity prices? Both? Time will tell.

As long as the Fed's balance sheet remains highly correlated with equity prices (at present for every ~$5 in equity market cap the Fed is putting $1 on its balance sheet), being short seems out of the question - that is as long as the market accepts the easy and cheap money policies around the globe. 

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