Risk Parity Paradise

The SPX went from 2906 to 2978 in 3 days last week.  The main reasons traders cited was China yielding to Hong Kong protesters to China setting a date for US trade talks in October.  But its odd how the price action doesn't match how skeptical most investors are of a possible trade deal between US and China.  Sure, it was "good news", but most are assuming that the talks will end up achieving nothing. 

So how does the SPX go up 72 points in 3 days on nothing substantive happening?  Because the trade war isn't as important as most people think.  If the market was trading solely on how the trade war was going, the SPX would be down over 20%.  But there are other things that most investors don't think about that are much more important. 

The most important factor that has changed from now since July, the last time the market traded at these levels is interest rates.  Really, raising tariffs 5% on Chinese goods versus a 50 bps drop in 10 year yields is like comparing a bb gun (5% tariffs) vs a M16 machine gun(50 bps lower 10 year yields).  The attention is focused on the tariffs and US/China talks, but the big fundamental change since July is the much lower interest rates. 

At SPX 2980, the lower interest rates makes me more bullish about stocks than when 10 year yields was 50 bps higher, as it was in July.  It doesn't make me bullish, but it makes me less bearish. 

The above chart is beyond ridiculous and it is something that almost nobody would have forecast at the beginning of the year.  If someone told you on January 1st, that the 10 year yield would drop down to 1.42%, most would guess that the SPX would be lower than 2500, not higher, and even if it was higher, not near 3000! 

The bond market rally this year is reminiscent of 2014, when bonds rallied strongly after a bad 2013, despite an economy that was still growing, and nowhere near recession.  That year, the SPX went from 1850 to 2060, for a 12% gain, while the 10 year went from 3.02% to 2.17%.  So far this year, SPX is up from 2500 to 2980, almost 20%, yet the 10 year has gone down from 2.68% to 1.55%.  2014 and 2019 are turning out to the be 2 best risk parity years since 2008. 

If bonds sell off hard and the 10 year yield goes above 1.75%, then I will get more bearish and consider putting on shorts.  Right now, it is an uphill battle for short positions when the bond market is so strong without recessionary data.  It is almost a Goldilocks scenario for the US stock market to get such low interest rates without a really weak economy.  The US Treasury market is more reflective of global weakness than US weakness. 

Usually in markets good for risk parity strategies, like we are in now, stocks have a hard time sustaining big selloffs.  The hedging effects of a strong bond market take a lot of pressure off of money managers who don't have to panic sell stocks because bonds are providing a great hedge.  Good news for bears is that the year after strong risk parity years is usually much less bullish, mainly because most of the positive stimulus from lower rates is used up, i.e. 2015. 

It is a FOMO market now, the weak hands sold a ton in August (see the equity fund outflows data for August), making the market less heavy with supply and more likely to grind higher in the coming weeks.  There is a weak seasonal period starting from September 20 after options expiration, as stock buyback window closes until late October.  So if I want to consider a short postion, it will be after the FOMC meeting next week.