Tuesday May 26

Stocks fall in spite of strong economic data. The S&P and the Dow both lose 1% to 2,104 and 18,041 respectively. The losses may be due to continued tightening expectations following Friday’s CPI numbers. Today’s data showed that durable goods orders (excluding transportation) rose 0.5% against expectations of 0.4% and there were also large upward revisions to the previous month. In addition new home sales were 517k against the estimated 484k. These numbers are signs of strength and they do not directly affect the Fed, which is mostly looking at unemployment and inflation numbers. The dollar index rises 1.3% and the euro falls to $1.08. The dollar’s strength may also have contributed to losses in equities. The Treasury yield falls 9 bp to 2.14% reflecting the weakness in equities and concerns in Europe. In Europe, concerns about Greece continue, with the Greek ten year yield rising 55bp to 11.92%. Election results in Spain cast further concern regarding the future of the EU.

Dividends and stock buybacks are set for a strong year, and are likely to exceed $1T. This trend has contributed to momentum in equities that has pushed indexes to record highs. Companies are holding large amounts of cash, and are skeptical to invest given the current economic climate. Dividends and buybacks are a direct way to return money to shareholders. On a large scale, if companies choose to do this instead of investing in new projects it may put negative pressure on the economy according to some activist investors. Stock buybacks are one way to grow EPS. In addition, dividend stocks are an attractive alternative in the period of low interest rates.

Difficult conditions in bond markets continue. Illiquidity has spread to bond futures, specifically futures tied to the German bund in the recent selloff. Bond futures are similar to equity futures, and allow investors the obligation to buy or sell a bond on a specific date at a specific price. During the bund selloff volume in bund futures increase, however traders still find that large trades move prices. These markets still have more liquidity compared to the bonds themselves. Typically bond futures allow for investors to gain exposure to the market if owning the actual bonds is difficult.

Last month Bill Gross called the German bund the “short of a lifetime.” Following his comments the yield shot up from 0.05% to around 0.80% at its peak. In hindsight, Gross says the trade was well timed but not well executed. In spite of his prediction that bund prices would fall, his unconstrained bond fund lose 2.5% this past month. He expected that bonds would fall but trade in a tight range rather than fall dramatically. According to Gross, in the low rate and low return environment investors should find value in differences in bond yields around the world. Some bonds may be overpriced and some may be underpriced. Consequently, investors should look for the least overvalued bond to buy, and the most overvalued bond to sell. For example the spread between US Treasury yields and German bund yields is currently 175 bp. The historical long term average between these two securities is 25 bp. This suggests that Treasuries are undervalued and/or bunds are overvalued. By buying Treasuries and selling bunds, the trade becomes profitable when the spread tightens.

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Tuesday May 26

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