Hey There Income Hunters,
Well, yesterday was another incredible day in the markets, with higher prices for Big Tech stocks and Treasury bonds.
And, oh, a much higher inflation report.
The consumer price index (CPI) — the most important driver of market prices — was released …
And the annualized level for inflation was 4% — and that is NOT a good number for the markets because:
Inflation demands much higher interest rates on bonds, which forces the price for growth tech stocks to adjust downward.
I’ll explain …
To value stocks correctly you need to compare their return to the risk-free return of government bonds.
For growth tech stocks that are considered long-term investments, you want to compare them to the US 10-year Treasury rate — it’s the benchmark interest rate that drives the value of all global securities.
Let’s take a quick look at the 10-year compared to the NASDAQ 100 (Ticker: NDX):
Are you surprised at how tightly correlated interest rates are to growth tech stocks?
By adding the 10-year rate to your dashboard and watching it closely you increase your performance and your profits.
Historical Comparison of Stocks vs. 10-year Bonds
The chart below illustrates historical valuations calculated using S&P 500 10-year returns and the S&P risk premium compared to 10-year yields.
Notice the inflationary period from 1965 to 1975 … 10-year yields were forced much higher due to inflation pushing stocks risk premiums into negative territory.
Again in 2000, when the S&P soared during the dot-com bubble, risk premiums moved heavily into negative territory.
Today the S&P returns are once again below the yield of the 10-year, and earlier this year 10-year rates spiked due to higher inflation.
Sure enough, the NDX suffered through a correction…
The iShares 20+ Treasury Bond ETF (Ticker: TLT) is an excellent stock I use to trade as a proxy for the US 10-year…
The ETF is extremely liquid and has liquid options to trade, as well. Trading TLT against stocks when correlations breakdown offers traders a new revenue stream.
Let’s take a look at the TLT in comparison to the NDX this year:
A couple of observations from the above chart …
- Notice how closely the NASDAQ 100 tracks TLT on the downside as shown by the red ovals.
- Check the green oval, top right. The correlation has broken down, and I think it is a valuable signal telling us that tech valuation is getting a bit stretched.
When you can find tight correlations between separate asset classes, it provides excellent insight into the major flows driving the markets.
When viewing the market overall, analyze the relative performance between stocks, bonds, the dollar and inflation …
In the big picture, bonds and stocks are inversely correlated, so when they diverge, it can be a powerful signal as to changes in flows.
Inflation is by far the most powerful force in the markets — and one that we will be dealing with for years thanks to a plethora of geopolitical, economic and monetary forces.
Bring It Home
Based on yesterday’s CPI number (+4%) against a Fed target of 2%, our central bank is now between a rock and a hard place.
The Fed cannot raise rates — they can only talk tough.
And talking tough is not going to slow down inflation.
The stock market may be rolling over, and I have two bearish vertical SPDR S&P 500 ETF Trust (Ticker: SPY) put spreads — 427/417 and a 435/430 — on to Aug. 20 expiry.
I am also looking to buy a bearish spread on XLF because I think the banks will have a very tough time making money going forward.
Until then …
Live and Trade With Passion My Friends,