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The Bond Correction Is Becoming Ugly!

 February 04, 2013 02:26 PM

A new catch word is spreading in the financial media, seeming to take over from the aging popularity of the phrases ‘risk-on' and ‘risk-off' of the last year or so.

The word is ‘rotation' and is being used to describe the supposed rotation of money out of bonds and into stocks – as it's finally being realized that bonds are in a correction.

I don't know if the money coming out of bonds is going into stocks – or vacation homes, or collections of single-malt Scotch and fine wines. Although stocks would be a reasonable assumption.

All I know is that money has been coming out of bonds since technical analysis and technical indicators reversed from a buy signal to a sell signal on August 16, and profits are being made in ‘inverse' bond etf's that go up in price when the price of bonds go down.

[Related -The S&P 500’s Worrisome Downturn In Drawdown]

Technical analysis doesn't identify where the money that is coming out of bonds is going or who is doing the selling. It also doesn't know which, if any, of the ‘big picture' conditions might be causing the sell-off, or if it's just profit-taking from the overbought condition.

Nor does it care. All it knows is that money flow and momentum ran out of steam and reversed to a degree sufficient to trigger a sell signal. Which means someone began selling so heavily that it even offset the significant buying of the Fed's QE programs, and continues to do so.

[Related -Deflation Warning: The Next Wave]

That happened back in August, and with the ‘rotation out of bonds' (why is Wall Street so reluctant to use honest words like correction, decline, even plunge), finally being noticed and showing up in headline stories, the correction seems to be accelerating.

The iShares 20-year bond etf TLT has now lost 12.5% of its value in 6 months, an annualized pace of -25%.   

When will it end? The flip answer would be when we get our next buy signal.

But as the top chart shows, bonds are still overbought well above the base price they pulled back to even in the panic crisis years of 2008 and 2009. If they are headed down to that base again they would have quite some ways to go yet.

Investor Sentiment.

For many years I have preached that investor sentiment cannot be used as a market-timing tool, but only as an indication (when it reaches levels of extreme bullishness or bearishness)  that it's time to watch actual technical indicators more closely, particularly those that measure conditions like reversals in money flows, momentum, internal strength, etc.

In last Saturday's post I noted that "This week's poll of its members by the American Association on Individual Investors showed the bullish percentage has jumped to 52.3%, and bearishness has dropped to only 24.3%. That's getting close to what our work has shown to be a danger zone, when bullishness rises to 55% or above and bearishness drops below 20%, where we need to be watching technical indicators more closely."

But this week the poll showed bullishness dropped to 48.0% while bearishness remained at 24.3%. It does indicate how individual investors tend not to follow a particular methodology or strategy and let their outlook be influenced by individual news items, or a one or two-day market reaction. (The poll is released Wednesday night each week, and on Tuesday it was reported that Consumer Confidence plunged in January, and on Wednesday that GDP growth had unexpectedly turned negative in the 4th quarter, and the market closed down on Wednesday).

With the market hitting new highs yesterday, the poll next Wednesday will probably show bullishness bounced back, unless the market's spike up yesterday has no follow through.

But in any event, the slow climb in the AAII investor sentiment poll to levels usually seen at rally and market tops, seems to indicate that short-term pullbacks notwithstanding, the favorable season rally is likely to continue.

But we will simply follow our indicators.

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