Contrarians Should Prepare for an Equity Rebound

It’s not easy to stay calm in a grinding down market. Yet, that’s exactly what investors should be doing during difficult trading periods, including the current decline. That’s because stock prices are marching lockstep with bond yields, and the stunning spectacle is reaching what could be a climactic period prior to a swift turnaround.

Here’s the setup:

  • The U.S. Ten Year Note yield (TNX) has reached multi-year highs as the Federal Reserve remains hawkish;
  • Some are now calling for bond yields as high as 13% over the next seven years; and
  • Rising bond yields have triggered selling in stocks.

Of course, no one knows when the selling in either market will stop. Yet predicting interest rates seven years into the future is a bit on the extraordinary side. Instead, practical contrarian investors should be planning for a closer day when stocks bottom. This is especially useful when stock market fear indicators such as the CNN Greed-Fear index are hitting their lows for the cycle just as extraordinary rhetoric about the future is rising.

In this article, I will review the pertinent macro aspects of the selloff and offer a reliable trading vehicle for when things around.

A Quick Primer on Bonds, Stocks, and the Fed

The bond market is an eye glazing topic at parties and the water cooler, even the virtual water cooler (via Slack) for those who work from home. Yet, for stock investors to ignore the effect of this multi-trillion dollar market on stocks is folly, as when bond yields rise, stocks usually fall in price.

Think of the bond market as an echo chamber for the Federal Reserve. When the Fed frets about inflation, it raises interest rates. When the Fed raises interest by announcing its most current target rates after its Federal Open Market Committee (FOMC) meetings, it reinforces its actions by selling bonds in order to bring the market in sync with its intentions.

Bond traders follow the Fed by also selling bonds. The combination leads to a rise in market interest rates; reflected in both bond and treasury bill yields.

In turn, higher market rates affect borrowing rates in the corporate sector, mortgages, credit cards, automobile loans and every other consumer rate. Higher borrowing rates decrease economic activity, which is the Fed’s goal in order to engineer a cooling of inflationary pressures.

For its part, inflation reduces the value of a bond’s dividend based on its influence on real yields; the actual amount investors pocket when bonds pay dividends.

For instance, if a bond pays 5% in interest, it offers a 5% yield. If inflation is at zero, the real yield is 5%. But if inflation is at 4%, the real yield of the bond falls to 1%. If inflation rises to 6%, the real yield is -1%. In other words, inflation erodes the value of a bond. Thus, during inflationary times bond investors sell their bonds and yields rise.

But wait, there’s more.

When the Federal Reserve raises short term interest rates, for example the Fed Funds rate, it also causes the yields on short term bonds such as Treasury Bills (T-Bills) to rise. This makes lower risk interest paying instruments such as T-Bills, money market funds, and CD’s attractive to investors.

The higher the short term rates rise, the less attractive longer term, higher risk bonds such as treasury notes become, prompting investors to sell, and raising yields further.

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These higher yields with lower risk compete with stocks for investor capital. Eventually interest rates reach a point which triggers selling in stocks as investors move money into the lower risk higher yielding instruments.

All of which brings us to the present as interest rates have reached a point where stock investors are decreasing their stock holdings as money market funds and treasury bills are more attractive investments than stocks based on a risk/benefit ratio.

Bond Yields Are Getting Absurd

Last week in this space I reported a striking development in the yields for the U.S. Ten Year Note (TNX). The take home message was that yields were reaching a point where in a normally function market a reversal to the mean was a possibility. The yield at that time was just above 4.5%. As I write, TNX is now nearing 4.8%. The U.S. 30 year Treasury Bond yield rose as high as 5% in a recent overnight trading session.

I’ve pointed this out before, but it’s worth repeating. The rise in bond yields has gone too far as the economy is not growing fast enough to support these levels given the amount of debt held by corporations, investors, and households. If this keeps up, the rise in defaults in commercial real estate will likely increase as will the potential for defaults and bankruptcies increase for businesses and individuals.

There are plenty of data points to support this view. The private payroll numbers recently released by ADP were almost half as robust as the consensus estimates. I would not be surprised to see a lower than expected September payroll report.

At some point, the currently high rates increase the risk of the economy falling into a recession, which may be deeper than many expect.

The stock market, which had held up quite well until August is now beginning to price in a slowing in corporate earnings. Moreover, a long term reckoning of expectations beckons as the S&P 500 index (SPX) is now testing its 200-day moving average, the dividing line between bull and bear markets.

If there is a bright spot it’s that stocks are increasingly oversold as the RSI indicator (RSI) is hovering near the 30 area, as the Accumulation/Distribution (ADI) and On Balance Volume (OBV) indicators are also flattening out after their recent moves down. When ADI flattens out or rises it’s a sign that short sellers are getting out of positions. Rising OBV is a very reliable sign that buyers are overwhelming sellers.

Together, these three indicators suggest that once bond yields calm down, stocks will likely rise as selling pressure will likely be exhausted.

QQQ Looks Interesting

The current action in the stock market looks plain awful. Yet, it’s always darkest before the dawn as the more stocks sell off, the more likely a major bounce will eventually materialize. Thus, with an increasingly oversold market and bond yields that are ripe for a reversal, contrarian investors should keep tabs on potential places to put money when things eventually calm down.

One easy trading vehicle to consider is the Invesco QQQ Trust ETF (QQQ). That’s because, as I described in this article, the tech stocks in QQQ grab the headlines, but under the hood, QQQ is actually a well-diversified portfolio of large cap stocks. Moreover, because of its holdings and its popularity this ETF is almost guaranteed to rise when the market turns around.

Even as the market has been selling off lately, QQQ is starting to show signs of stabilizing, an early sign that money is starting to trickle into the shares. You can see that in the market’s recent bounce after testing the $350 area. In addition, both the Relative Strength Indicator (RSI), Accumulation/Distribution Indicator (ADI), and On Balance Volume (OBV) indicators are acting in a similar fashion to what we saw above in the S&P 500.

At some point stocks will rebound and investors who look ahead and prepare a shopping list will be rewarded.

Bottom Line

The Federal Reserve has triggered panic selling in bonds. Bond yields are likely trading at levels which would me more fitting for higher levels of inflation than what we are experiencing. Thus, they are due for a pullback, which may be accelerated if the September jobs number is weaker than expected.

The stock market has been selling off in response to the expected effect of higher interest rates on corporate earnings and the overall economy.

On the other hand, fear indicators are increasing bullish as many gauges of money flows in the stock market suggest that although the coast is not completely clear, some money is trickling back into the market during the current selling spree as bargain hunters pick through the rubble.

When bond yields reverse, the odds are better than even that stocks will stage a rebound. As a result, investors should be compiling a shopping list during this selloff.

The QQQ ETF is a great place to put some money to work in any rising market as its popularity almost ensures that it will gain ground in any up market.

P.S. If you’re looking for a steady source of income amid these uncertain times, consider the advice of my colleague, Jim Pearce.

Jim Pearce is the chief investment strategist of our flagship publication, Personal Finance. Jim has unearthed a once “secret” income power play that’s giving everyday investors the opportunity to collect huge payouts, regardless of Fed policy or the ups and downs of the markets. To claim your share, click here.

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