Often, I like to check and see how the stock/rate correlation is coming. In the past, before the Federal Reserve began tinkering with markets, a close correlation between the S&P and the 10 year government rate could be seen. They moved in lockstep. For this reason, the concept of diversification became so popular.
Several years ago, I posted a longer term chart of this correlation and showed how far apart stocks and rates have gone. When the market melted down two years ago, surprisingly, the S&P line came back down exactly to the level of the rates! Again though, we can see how the S&P has rallied while rates have collapsed. I believe that it is a certainty that eventually, the two lines will meet.
If my theory is correct, how might one maximize investing for this inefficiency? You must be SHORT (or playing for the investment to go down in price) both stocks and bonds. Why would such a strategy make sense? For the following reasons:
1. You are still maintaining diversification in your portfolio. Most people play stocks and bonds to go up, allocating a percentage to stocks and a percentage to bonds. I suggest playing them to go down.
2. The Federal Reserve has purposely manipulated interest rates to be lower, forcing investors to move to riskier assets, thus stocks and other assets such as gold have all rallied. With stocks being back again above pre-crash levels and bonds being at all time highs, there is a great risk that once the Fed exits this situation (if they possibly can), then these asset classes sitting at their highs are bound to go down.
The positioning has thus far been effective. Yesterday, interest rates rose sharply while the stocks marked time. Today rates backed down slightly as fears of the revival of the European crisis again filters into the headlines. Stocks tumbled.
Should we have another European panic, what is the worst that could happen to your portfolio? Bonds will rally hard again but the stocks will fall hard again. So you have the diversification, just as had you been long stocks and bonds.
The wild card though is what happens when the Fed has to start taking money out of the system to prevent inflation? Many say that the rates will rise but that is good for stocks and they will rally another 20-30%.
But I don't believe this to be the case. I believe that the Dow Industrial Average is building a major head-and-shoulders top. I see the Fed eventually running out of tools and experiments, leading to sharply rising interest rates and potentially a government default. If nothing else, government bonds will be junk and you will be richly rewarded for swimming against the trend.
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