A strengthening U.S. economy, along with rising equity markets and interest rates, was the consensus forecast among economists as 2014 began. It hasn't turned out that way, and a prominent interest rate strategist presented a fascinating, compelling explanation of why it didn't.
Kevin Ferry is the founder of the Chicago-based company Cronus Futures management and is among the most respected voices in the arcane but very important worlds of Eurodollars, credit swaps and interest rate futures.
Mr. Ferry advanced a theory that the March sell-off in growth stocks, and the decline in U.S. bond yields, is the result of a massive portfolio re-allocation by pension funds.
"Public corporate pension funds, thanks to the over 30% gain in S&P500 last year and the rise in rates …. are 100% to 110% funded. At the end of the first quarter a number of large pension funds were up 8% on the year because of their holdings in the [momentum] stocks… it became attractive to reduce growth assets and increase hedge [fixed income] assets."
In other words, pension funds became overweight equities because of the strong performance of U.S. growth stocks in the 12 months ending February. In response, they took profits in successful stock investments and bought bonds with the proceeds to help meet future liabilities.
The chart below, comparing the yield of the 10-year U.S. Treasury bond with the technology-heavy Nasdaq Composite index, suggests the theory is at least partially correct.
Nasdaq Composite index vs U.S. Treasury 10-year yield
SOURCE: Scott Barlow/Bloomberg
Beginning March 18, the Nasdaq and bond yields began moving lower, roughly in tandem. This is what we'd expect – the selling of Nasdaq stocks drove the index lower and, since bond prices and yields move in different directions, the increased buying of bonds drove yields lower.
For investors, the bad news is that high valuation momentum stocks like Facebook Inc. and Twitter Inc. are unlikely to recover anytime soon. U.S. public pension funds are generally much better funded than they were, they're content with longer dated bonds to ensure they'll have cash on hand to match the benefit payments they'll have to make, and so they don't need to increase their portfolio risk right now.
The potential silver lining is that the collapse of the mini tech bubble will see the more conservative, valuation-conscious investment strategies move to the fore. Last year, attempting to outperform the equity benchmarks virtually forced investors to chase stocks like Amazon.com Inc. (which was trading at over 500 times trailing earnings) and praying that they won't fall apart – in vain, as it turned out.
A more conventional market environment where stocks with attractive price to earnings ratios and reliable growth outperform is much more navigable for investors and should be welcomed. It reaffirms the proven, long term benefits of prudent stock picking and risk management.
Follow Scott Barlow on Twitter at @SBarlow_ROB.