Stocks vs. Bonds: Who’s Right?
Featuring Michael Purves
Published on: June 13th, 2019 • Duration: 16 minutesMichael Purves, chief global strategist at Weeden & Co., revisits his short utilities trade from last month and highlights the current dichotomy between bonds and the stock market. He takes a deep dive into both the bullish and bearish arguments for Treasuries and the S&P 500, points out why shorting volatility make sense right now, and considers a specific put option on the VIX to make the trade, in this interview with Justine Underhill. Filmed on June 12, 2019
JUSTINE UNDERHILL: Welcome to Real Vision's "Trade Ideas." Today, we're sitting down with Michael Purves of Weeden and Co. Great to have you back.
MICHAEL PURVES: Thank you. It's always great to be here.
JUSTINE UNDERHILL: So last time you were here, which was early May, you were looking at the market and you were bullish on banks and somewhat bearish on utilities. And that trade didn't necessarily play out, especially with the big sell-off that we saw.
MICHAEL PURVES: Yeah, well the bullish trades on XLF did play. I think I had mentioned during that interview that the easy money was certainly behind. The XLU was the theme I was really excited about at that point because I saw a few different factors lining up. One, I saw this bond market that had been on a ferocious tear with yields collapsing.
The second part, and probably in some ways the most important part, was that the relative valuation of the utilities relative to the S&P 500 was at multi-year highs and at levels that were typically not sustainable. Now, there's various ways to look at valuation. But I think with utilities, which are really yield plays, I look at the spread between the dividend yield on the utilities with the S&P dividend yield.
And if you look at the chart, you can see that over time, every time it got that tight, it typically preceded a 10%, 15% or so sell-off in utilities. But really, there was sort of a two-factor or two catalyst condition for that trade to work. The one was that the equities and risk assets would stay in a constructive profile, which broadly it did for most of it. We had some volatility, but it wasn't Earth-shattering.
And the second thing was the bond yields would go higher. And that would allow that relative valuation to start mean reverting and put downward pressure on the XLU. In each of the prior instances, you'd see bond yields typically would rise. Maybe not dramatically, but they would typically rise to some magnitude, in some cases pretty sharply.
And in this situation, since I think the interview was on May 2, since then, bond yields have only gone lower. Referring to treasury yields, the 10-year in particular. So that was sort of confounding. So the trade has not worked. I do think we are setting up a good situation at some point. But given how ferocious this bond rally continues, I'm not recommending going back into more XLU puts, even though the stock is a bit higher.
I think the trade will play at some point over the summer, but I'm just not quite there yet. With short-dated option trades, timing is really important. But I think one of the things that you learn through each trade exercise is how interesting markets can be. And one of the dominant themes in the markets is that there's the treasury market, the rates market over here on one page, and then you have credit-- high yield, investment grade credit slash equities-- over here.
And it almost seems like the risk assets, meaning the credit and the equities, are looking at one set of economic numbers and then the bond market's looking at a different set of economic numbers. And this divergence is really peculiar. Now part of this, of course, is that lower bond yields can reduce the cost of equity for the equity complex.
And clearly, the bond market seems like it's trying to nudge Powell into a much more dovish stance than what he gave us back in March and that whole pivot through from December to January into March there. And that will be revealed a little bit next week at the FOMC. If you look at the ratio of 10-year yields to nominal GDP, it's been coming down, and down, and down.
Now, nominal GDP, these are historic figures, and so forth, but it arguably looks like the bond market's looking at GDP in 2020 at 1%, 1.2%, 1.3% levels, a major drop from the consensus estimates. And you look at the US economic condition right now-- is there evidence of some slowdown? Absolutely. You look at the Citi Surprise Index. That's been really underperforming.
But a lot of that, again, is just sort of adjusting to the fact that people got a little bit overexcited after tax stimulus there. And so yeah, some of the economic metrics are underperforming, but the overall economy, as we're talking right now, is really in pretty good shape here. So why is the bond market pricing in so many cuts over the next year and a half?
Yields have collapsed almost 120 basis points or so from September and early October, when the problem was the other way around. Jamie Dimon was calling for 5% or 4% bond yields, and Powell was saying, far from neutral. And that got the volatility party started in Q4. We just put in that record ISM print. I think a lot of caution-- trade tensions were brewing. Certainly, Trump was pushing trade in September and October.
Is the economy today really ultimately that different than it was before? I would suggest to you it's not. What is different is how the markets are pricing in a contingency next year. In other words, the bond market almost seems to be pricing in a tail scenario that, oh, my god, these trade wars are going to drive us into, if not a recession, a severe reduction in GDP. And the equity and credit markets just haven't figured this out yet.
Whereas the equity markets and the credit markets seem be saying, you know what? Those consensus estimates, those Fed estimates, they'll probably move around a little bit. Maybe they'll get a little bit weaker, but certainly nothing like what the bond market's suggesting. In other words, the equity market is almost arguably behaving a little bit more like the bond market used to.
But the pricing of the Treasury market is a little bit more complex than just that. One of the things that I've been really focused on is that the 10-year Bund yield in Germany has been plunging. And it's actually made fresh lifetime lows. The correlation of that 10-year Bund yield with the 10-year Treasury yield has been going ever higher over the last six or seven months. So in other words, the Bund yield has been dragging down the Treasury yield.
If you're a pension fund, and let's put the FX hedging discussion aside. But let's say you're Japanese or German pension fund. Where would you rather buy paper today? At minus 20 basis points in Germany, or get the same credit in the US for 200 plus? So that ultimately, to me, is a suggestion that the Treasury market is a little bit beholden to some of these global dynamics.
And back to XLU trade for a minute. Let's say we do get good economic data in Germany, and let's say we do get a hawkish replacement for Mario Draghi in September not too far away. Well, if the Bund yields start rising by 30 or 40 basis points quickly, which is where they spent a lot of the last couple of years before this recent Bund rally, well, that's going to probably drag up our Treasury yields, too, regardless of what's going on here.
And it may not be basis point for basis point, but it'll be something material, something to at least be aware as you're thinking about these trades.
JUSTINE UNDERHILL: Do you see this dynamic lasting with the divergence between equities and bonds?
MICHAEL PURVES: Well, that's a great question. I don't think ultimately-- so who's right, the bond market or the equity slash credit markets? I would suggest that maybe both are a little bit wrong. Maybe the bond market's overdone it, and maybe it's importing some of this dynamic from Germany that may be very specific to some other European situation that's less relevant here.
On the other hand, there's a rational part of the bond market discussion, which is that-- and this is putting aside the tail scenarios that trade tips us into a global recession and all that-- but simply that, hey, look. That weak rest of world growth-- maybe we are starting to be, not just in the earnings point of view, but in the economy, felt in some of the data here.
So yeah, sure. Some of the US data has been softening, will probably continue to soften. But on the equity side here, I think, sure, there can be a view that there could be some consolidation here. We've had a vicious rally from December up through April, then we had this kind of V-shaped correction there. But there's a lot of very strong structural factors in place for equities here.
And I think you're going to ask me about a specific trade to play sort of more of a risk--
JUSTINE UNDERHILL: Of course.
MICHAEL PURVES: Maybe some near-term risk on conditions here as the markets are just sorting this divergence out. So one of the trades I think that's really interesting right now is that the VIX has been elevated. So you're starting to see that some of the trade tensions are starting to be priced in to the markets pretty well. And there's almost a little bit of a jadedness.
One of the things I like to look at is the Korean yuan, the implied volatilities on those currencies. If you look at the risk reversals, they were heavily skewed back a few weeks ago, saying, oh my god, we're really nervous. This yuan's going to get really weak because we were directly impacted by this, given the nature of their economy.
But those have been coming in. The Chinese currency has been really pretty stable through a lot of this stuff. That's a more complex story than just simply trade, but it has been certainly exerting some stability and not crashing through 7 like some bears might have guessed. If you look at the EEM, it's been actually outperforming the SPX on a lot of days.
What this is ultimately setting the stage for is that a lot of the volatility that we've seen in the markets may start coming down in the near term. So the trade, specifically for a risk on condition, even if you're beared up, and you're buying spy puts, and all that, it's always nice to have a cheap trade the other way in case you're wrong.
And so what I like here is buying the VIX 14 July puts. Right now, I think they're about $0.20, $0.25. They move around a little bit. So the VIX is, right now, in sort of that 16 to 17 range. The contract associated with those puts is a little bit higher because of the nature of the VIX curve. And look, I think there's all sorts of reasons why the floors of the VIX will climb a little bit higher over the years. And they have been doing that.
But can we get a move from where we are now on the VIX down to 14, and can those $0.20, $0.25 puts double in value pretty quickly or go higher? I really think so if the market continues just to consolidate.
One of the really fascinating things about the VIX and the volatility within the SPX is, so what have we had over the last couple weeks? We had a really severe V. And that risk on that we just got was, I think, taking a lot of people by surprise. But it came on really strong, but it came with volatility. So just last week, there was four days the market was green, but the day-to-day closes, two of them were meaningfully over 1%. One was over 2%. And the average for those four days was well over 1%, which would imply a VIX of 16, 17 plus.
The thing is is that if the markets get into-- even whether it's a consolidation around these levels, or certainly a bull trend-- that realized volatility within the SPX is going to fade the levels that we saw last week. And as that happens, that's going to drag the VIX down with it.
JUSTINE UNDERHILL: So this is a way to play a consolidation in the overall S&P.
MICHAEL PURVES: Yeah, a consolidation or a bull rally. Typically, these Vs in the SPX-- that upward momentum is not really that sustained there. So I think there's always bear arguments out there, and there's some good ones right now. But what I'm saying here is if you can find a cheap option that will give you leverage the other way, it's sometimes a really good opportunity.
JUSTINE UNDERHILL: So what are some other factors that you're looking at that suggest that volatility should fall from here?
MICHAEL PURVES: There's a few other factors besides the Korean yuan volatility, that risk reversal showing some, hey, we get it. Maybe the world's not going to fall apart, in the next few weeks, anyway. You see the MOVE index had spiked in a very substantial way. That often tends to sort of ricochet through and echo into other volatilities. But the MOVE index has been collapsing over the last few sessions. So that's one factor.
Another thing I'm looking at is just simply technicals here. The MACD deal on the daily charts on the SPX has been starting to get signal that slowly but surely, the bulls are getting a little bit more momentum here. So after the big V, will you continue to find some support here? I think so.
JUSTINE UNDERHILL: So what would you say is the biggest risk here to this trade?
MICHAEL PURVES: Well, I think very simply, the risk is that the VIX goes the other way. And there's all sorts of reasons why that can happen. But do you get an ugly G20? Maybe Powell comes out-- he's coming out next Wednesday-- and does he shock the markets with some very hawkish stance? And that would be a risk.
JUSTINE UNDERHILL: Can you break down this trade in 30 seconds?
MICHAEL PURVES: Very simple. You can spend $0.20, $0.25 to buy some July 14 puts on the VIX. It's a risk on trade, but it's also a view that the drama that we've had in S&P volatility is ultimately going to fade.
JUSTINE UNDERHILL: All right, great. Michael, thank you so much for joining us.
MICHAEL PURVES: As always.
JUSTINE UNDERHILL: So Michael suggests buying the July 14 strike put option on the VIX for approximately $0.25. He recommends taking profits if the premium doubles. Just remember, this is a trade idea and not investment advice. You should do your own research, consider your risk tolerance, and invest accordingly. For Real Vision, I'm Justine Underhill.