Sunday, November 02, 2014

Learning From Relative Performance: Lessons From Fixed Income Measures

I recently noted that we can learn quite a bit from the relative performance of stock market sectors.  The same is true for the relative performance of financial assets in general.  How traders and investors deploy their capital speaks volumes regarding sentiment and perceived opportunity.  Today's post begins a series on using ETFs to create informative relative indicators.  In this post, we're looking at a few relevant fixed income ETFs and what we can learn from their relative performance.

The top chart is a relative measure I've tracked for a while:  the relative performance of high-yielding corporate bonds (JNK) to high quality corporate bonds (LQD).  In general, when investors are risk-seeking and feel secure about economic conditions, they are willing to reach to pursue lower quality fixed income assets and obtain higher yields.  Conversely, in a risk-averse posture, investors will flee lower quality assets and seek the safety of high quality.  This is precisely what we see in the relationship between JNK and LQD.  Dips in that relationship have generally corresponded to risk-off periods in the stock market.

Note that JNK:LQD topped out well ahead of the stock market and, indeed, is below the peaks seen in 2010 and 2011.  It appears that the reach for lower quality yield has been diminishing in recent years relative to the reach for stock market returns.  More on that in a bit.

The second chart takes a look at the relative performance of high quality bonds (LQD) to stocks (SPY) overall.  Again, we see the pattern of bonds outperforming during risk-off periods in the stock market, but notice how very attenuated this pattern has become in recent years.  Quite simply, high quality bonds have been in a downtrend relative to stocks in the past few years, in part reflecting the crushing of yields due to the zero interest rate policies of the Fed.  (A chart of stocks versus international bonds looks quite similar).  As bonds have gone out of relative favor, the volatility of the stock/bond relationship has decreased notably, so that--during risk-off periods--we're seeing less flight to quality vis a vis bonds than during 2010 and 2011.

The bottom chart looks at the relative performance of a higher yielding stock sector (XLU) versus stocks overall (SPY).  Note a similar downtrend and declining volatility, though not as pronounced.  The defensive sector still tends to outperform during risk-off periods, but as these periods have been milder in recent years, we're seeing less investor flight to safety.

I believe tracking the relative performance of fixed income to stocks continues to provide information, but anchoring our expectations on relationships we observed pre-2012 would be a mistake.  Swamping the relative rotations from stocks into yielding instruments has been that Great Rotation that has been anticipated for years:  with artificially low interest rates, money has systematically moved from fixed income into equities.  This is a major dynamic underpinning the current bull market.  After all, even with the recent bull market action, stocks still yield more than most bond funds.  Amidst very low bond returns, the flight to quality has been replaced by a flight to opportunity.

I suspect this, too, shall end badly at some point.  With commodity prices on their back and inflation nowhere in sight--and with central banks overseas in further asset-buying modes--it is difficult to see yields rising in the near term.  Should this continue to fuel stock market interest, we could see shares move from generous valuations (and rich ones in some cases) to unsustainable ones.  One sign of this would be a similar flight to stocks across Europe and Asia, whose stock markets have lately underperformed the U.S., but who now are further embarking on their own currency-devaluing, yield-crushing rounds of asset purchases.  

We live in strange times.  One takeaway from the relative fixed income indicators may be this:  In a global world, the old stock market wisdom of "Don't fight the Fed" has been replaced by "Don't fight the banks."

Further Reading:  Risk Management and Learning from Losses