TBT vs. VXX, Who is right?

May 07, 2014, 09:11 am ET, BY Thomas H. Kee Jr- Editor, Stock Traders Daily| Editor: Thomas H. Kee Jr. (Follow on LinkedIn)

We should listen to the bond market when the bond market moves because this is where big money invests most of their money, and it has been saying something during the most recent market cycle.  The bond market has been telling us that the recent increases may not hold. 

However, the fear gauge does not support this, and only when the stock market really starts to fade will the VIX respond.  Until then, the fear gauge is likely to remain subdued. 

Yes, there are risks in the stock market that the naked eyes of smaller investors do not see, yes the last two quarters have seen negative investment into real estate, yes the last quarter was the first since 2010 where gross domestic investment in the US economy was negative, and yes the condition of the underlying economy is extremely weak (without stimulus), but the fear gauge does not reflect the risk.  The Gross Domestic Investment references above come directly from the BLS, and the state of the Underlying economy is defined by The Investment Rate (a natural growth indicator).

Interestingly, the bond market is absolutely the opposite.  Long Term Treasury Bonds are reflecting long term risk in the economy, but the VIX does not suggest an impending disaster.  To gauge this we watch two ETFs closely.  The first is iPath S&P 500 VIX ST Futures ETN (NYSE:VXX), which is related to the VIX, and the second is ProShares UltraShort 20+ Year Treasury (NYSE:TBT), which is the double inverse of the long term Treasury Bond.

My experience over the past 20 years has suggested that bond investors are much more careful than stock investors, they do their homework more diligently, and they have a much longer term time horizon most often.  That has made me consider the bond market as a better gauge of the sentiment of smart money than the stock market on a longer term basis. 

If this is true, the bond market is teling us that there are serious long term risks.  Recently, the bond market has been rallying, even though the stock market is still very close to all time highs.  That has caused TBT (trading report) to decline, something that might not make sense to the naked eye.

At the same time, in the face of these longer term risks, VXX (trading report) has been deteriorating daily.  There are very important additional deterioration factors at play in this ETF, but clearly the risk of an impending disaster n the stock market does not exist.  Even after Tuesday's meltdown VXX barely budged, and as of the pre market indicators when I wrote this, whatever gains happened yesterday in VXX were already reversed.  That tells us something about the short term sentiment too.

Specifically, this combination tells us that longer term risks are serous and being observed by more diligent investors, but immediate risks are not being perceived by equity investors.  The VIX is a fear gauge, and it is not reflecting an immediate risk.

With that, we need to ask ourselves who is right?

Eventually the VIX will corroborate the readings from the bond market according to our analysis.

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