Seeking Alpha: The Biggest Week in 2 Years and the Summer Crash of 2011

“It’s easy to have faith in yourself and have discipline when you’re a winner, when you’re number one. What you got to have is faith and discipline when you’re not a winner.” – Vince Lombardi

Since June 8, I’ve been publishing article after article arguing for why the market was likely to undergo a substantial decline at some point during the summer. My reasoning for arguing that the conditions favored a Summer Crash? First, the overwhelming bearishness that existed toward bonds. Second, the fact that the bond/stock price ratio had been trending higher since mid-February. Third, intermarket relationships, particularly relating to junk debt spreads, were reaching extremes.

And then came last week, the market’s biggest weekly move in 2 years. To put the week into context, the enormous comeback in risk assets in 5 days at quarter end ranks as being in the top 2.5% of all weekly gains for the market since 1950. Perhaps more stunning was the complete collapse in bonds and substantial increase in yields in government debt. Incredibly bright traders and bond managers have been commenting as of late that the move was breathtaking back into risky debt, and that it was nearly impossible for anyone to make money as a result because of the speed of the price action.

Markets have a funny way of doing the unexpected. For me, the move was particularly frustrating since I had just written a piece arguing for further declines for Mr. Marc Faber, who was kind enough to publish it alongside his Monthly Market Commentary just last Thursday. Was I completely wrong, or is this another head-fake that can still result in a Summer Crash? Let’s take a look at the price ratio of Bonds to Stocks to see what really happened last week. As a reminder, a rising price ratio means the numerator/TLT is outperforming (up more/down less) the denominator/IVV.

Bonds (TLT)/Stocks (IVV) – A Summer “Ratio” Crash

(Click charts to enlarge)

The blue line is a rolling 20 day (1 trading month) moving average. The relationship of bonds to stocks completely collapsed last week. In my series of articles arguing for a Summer Crash, I made the argument that the TLT/IVV price ratio should actually be closer to 1 given the stunningly low yields we saw just prior to last week’s move, and given the magnitude of outperformance in defensive sectors such as Consumer Staples (XLP), Healthcare (XLV), and Utilities (XLU) for the bulk of the year. One week gave back six week of bond outperformance relative to stocks, sending the price ratio to mid-May levels.

Are the conditions for a Crash now erased because of a single week that ranks in the top 2.5% of all weeks going back to 1950 for equities? Does the move even make sense given that there were weekly fund outflows out of equities last week? Sure, one could argue that Greece is resolved for now, but what about Portugal? Spain? Ireland? Forget about country sovereign risk – what about junk debt?

Equities tend to go through periods of hightened volatility when junk debt falls/yield rises, coinciding with an opposite move in Treasuries. When credit spreads widen, it’s a big warning sign. Take a look below at the price ratio of the SPDR Lehman High Yield Bond ETF (JNK) relative to the 7-10 Year Treasury Bond ETF (IEF).

When the ratio rises, it means credit spreads are compressing. When the ratio declines, it means credit spreads are widening. When credit spreads widen by a substantial amount (as they did minutes before the May 6 Flash Crash happened), watch out. Yes – there was a massive comeback in junk debt last week, which ultimately is what caused equities to recover as violently as they did. However, the move is too extreme. The JNK/IEF ratio has not gone back to new highs. If anything, the ratio appears to be headed back down again.

In conclusion? There was a reverse crash that happened last week, but these ratio relationships still need to be resolved. Given still historically low yields and still elevated outperformance in defensive sectors, I continue to believe the price ratio should be closer to 1, not 0.703 as it is now. What would confirm this is if Junk debt relative to Treasuries collapse once again and give back all of the outperformance gained last week.

Time will tell of course. The only thing I know for sure is that markets fluctuate.

via Seeking Alpha