Flexible Migration Strategy

When the world’s largest bond fund sees over $7 billion in net outflows, it tells us the tide may have turned against the bond market bulls. From Bloomberg:

The world’s biggest mutual fund keeps getting smaller. Bill Gross’s Pimco Total Return Fund shed $41 billion, or 14 percent of its assets, in the past four months through losses and investor withdrawals. The fund suffered $7.7 billion in net redemptions in August, Chicago-based researcher Morningstar Inc. (MORN) said today in an e-mailed statement, the fourth straight month of withdrawals.

Economy Holds Key To Bonds’ Fate

As we have documented on numerous occasions, the Federal Reserve has clearly signaled it would prefer to step away from non-traditional forms of stimulus in order to avoid another round of asset bubbles. The only question is will the economy be strong enough to withstand a complete wind-down of the Fed’s bond buying program. If the Fed implements according to their previously mapped-out tapering timeline, bonds may suffer further. From the Wall Street Journal:

Studies for the Financial Industry Regulatory Authority’s education arm and, more recently, Edward Jones have revealed a majority of investors don’t know that when interest rates rise, bond prices typically fall.

If the economy is strong enough, interest rates will continue to creep higher. If interest rates creep higher and the majority of investors do not know rising rates can negatively impact bond prices, it stands to reason that additional selling in the bond market will come as the losses pile up.

A Signal of Economic Confidence?

Small cap stocks have been market leaders since the November 2012 lows, which typically shows a bias toward improving economic outcomes. Similarly, if a small business owner is willing to borrow and invest in their business, it tends to signal confidence in business trends. From Reuters:

Small U.S. businesses took on more debt in July, pushing an index of borrowing to a six-year high and adding to evidence that the economic recovery is on firmer ground. “There is some optimism returning to small businesses…they are responding to some demand,” PayNet President Bill Phelan said in an interview. “As long as interest rates are within reasonable boundaries….a strong economy with demand is better than a weak one with low interest rates.”

Therefore, small cap stocks and small business borrowing provide some anecdotal evidence supporting the improving economy case, which could mean higher interest rates and more pain for bond investors.

Car Sales Align With Bullish Economic Case

Just as a rising borrowing index tends to signal confidence rather than fear, consumers that are willing to take on a new car payment are also demonstrating confidence intheir economic futures. From Reuters:

U.S. auto sales were on a pace to show a gain as high as 17 percent in August as the industry raced toward its strongest month since just before the start of the 2007-2009 recession. “The auto industry continues to be a bright spot in the economic recovery,” said Bill Fay, Toyota division group vice president and general manager.

The Market Has Spoken…Well, Sort Of

Investors and consumers have been known to exhibit confidence just before bearish turning points, which means the anecdotal evidence above may turn out to fall into the “false signals” folder. Our market model, which examines the current battle between risk tolerance and risk aversion, paints a much more balanced picture. As of Tuesday’s close, the model’s recommended exposure between risk assets and conservative assets was an even 50-50% split. The back and forth battle between bulls and bears can be seen in the chart below, which tracks the demand for stocks relative to the demand for bonds. The ratio has made no progress in either direction since early July.

Investment Implications – Ready To Migrate

If you pay attention to what is happening, you will not stray too far from the market’s asset pricing mechanism. That mechanism has said “reduce risk to account for the uncertainty, but do not redeploy your cash into conservative investments yet.” We have done just that by holding about half of our allocation in stocks (SPY) and leading sectors (QQQ), while offsetting the risk with high cash balances. When the markets begin to support the bullish or bearish case with conviction, we will migrate in a manner that allows us to remain in the pricing mechanism’s neighborhood.