Sunday Musings: Marching In Sync

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Chart courtesy of YahooFinance

Emails, along with references to articles about the impending bond bubble, keep coming. Some even suggest that now is the time to go short treasuries.

To recap, the happy trio is still marching in sync. I refer to the happy trio as being gold (GLD), the domestic stock market (VTI) and the domestic bond market (BND). Historically, these three asset classes do not move in the same direction at the same time, at least not for very long.

While gold has been referred to as a hedge against inflation in the past, more recently it has been a hedge against uncertainty and a sliding dollar in an environment supported by general deflationary tendencies.

Bonds on the other hand flourish when the economy is slowing down, or is perceived to be slowing, as interest rates fall to stimulate economic activity.

That is the time when stocks and bonds can rally in sync, but only up to a point. Once the pendulum swings the other way, and economic steam has picked up to a level where interest rates are being pushed up again, bond prices will head south.

The timing of the back and forth movement is not chiseled in stone, which is why there is some overlap before a major trend prevails again.

I think we have reached a point where something has to give. We are either in an environment of improving economic activity, which supports the stock market, or we’re not, which would be good for bonds.

The fact that the Fed is entertaining more quantitative easing via QE-2 next week is obviously a sign that the economy is lagging and not standing on its own two feet. In other words, the patient is still bedridden.

To me, that means we are at a crossroads where the stock market is hoping that QE-2 will be working so that we have justification for the current rally. On the other hand, the mere fact that the Fed feels it has to intervene can keep the bond rally going as well.

Sooner or later, only one of the two is going to be right. Either the economy recovers or it doesn’t. Alternatively, there is a good chance that it simply will sputter along for years to come.

While no one has the foresight to determine the eventual outcome, my guess is that the bond market will come out ahead as the perceived recovery will not materialize. This is not a prediction but merely my current view.

With everyone expecting a bursting of the bond bubble, is anyone considering a bursting of the current stock bubble? Remember, the recent stock rally is based on very rosy assumptions about the recovery. If they do not materialize, there is no reason for the major averages to hover around these lofty levels.

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