the debate of why rates are increasing isn’t that important for this post. What is important, is the reason they are not. Rates are not increasing because of the economy growing. They are not increasing because inflation or the expectations of inflation has shown up out of nowhere.
If that was the case, you might very well have seen a great rotation (from bonds into stocks), or at least some sort of variation of a rotation from risk-off to risk-on. If rates were rising because of growth, the decline in Treasuries would have been coupled with an increase in the stock market. Or defensive stocks would have lost ground to cyclical / high beta names. (Early in this yield correction, there was some outperformance in high beta, but as i wrote in my recent “Macro Update” I think that stems from prior underperformance and the need to catch up.)
This is not what we have seen in this – so far – minor sell-off. Everything has been declining. There’s no risk-off happening. It’s all “buy cash”. Investors are clearly beginning – and clearly only beginning – to price in a small portion of QE-less and eventually ZIRP-less markets.
So now, if QE & ZIRP were gone tomorrow, what’s the fair value of all these risk-on propped-up assets? Has the economy improved? Undoubtedly. But I’m pretty certain that if QE & ZIRP disappeared tomorrow, most of these assets would be more fairly valued another 10-15% lower from today’s prices.
So during a “buy cash” decline, would you want to be invested in stocks over bonds? Would you want to be in cyclicals over defensives? They actually might do better (especially from a risk/reward perspective), but there aren’t many places to hide.
Having said all that, I do believe that if you’re forced to sell cash and put your money to work, there are places to invest and/or hide.
Event driven names with very little or no correlation to the overall market are the seemingly easiest choice. There are also plenty of fundamentally defensive companies – not sectors that are typically lower beta etc. – but firms that are trading at or near cash/asset levels with lots of optionally on the upside etc. These are areas where you can either calculate odds and make decisions based on specific idiosyncratic event-driven ideas, or where at least you have a margin of safety in owning assets at a discount to what they’re worth.
Again, this is what I think has been happening these past few weeks. Moving forward, the talk of tapering might taper, Bernanke might yet again convince himself that the QE benefits outweigh their risks, and we’re back to hunt for yield and QE4ever all over again.
The takeaway moving forward is to keep a close eye on the 10-year… That yield number should be the driving force of most assets classes. And keep in mind, the higher it goes, it most probably won’t cause a rotation to risk-on assets and drive investors to equities, rather it’s signaling that investors are beginning to price in – somewhat – the end of QE & eventually ZIRP, and in that case we’re heading back to reality, a reality that bulls may not want to face.