The Markets Have a Message: Don’t Believe This Rally

As risky assets have rebounded since mid-February, the havens to which investors rushed during the earlier panic haven’t had an equivalent selloff

Amid the epic recovery in risky assets since mid-February, one thing has been missing: an equivalent selloff of the havens to which investors rushed during the earlier panic. Instead of the usual reckless rally, this has been a very cautious comeback.

Some of the highest-risk assets chalked​up spectacular gains​during the recovery. The J.P. Morgan Emerging Markets Currency Index rose 8%, a gain matched in such a short time only once since the index was created in 2000. U.S. junk bonds leaped 8% in price, the biggest jump in the Bank of America Merrill Lynch benchmark over such a short period since the summer of 2009, when the country was just emerging from recession.

U.S. shares didn’t miss out. From its February low, the S&P 500 recorded its biggest gain over an equivalent period since late 2011, rising more than 12% by the middle of last week; it is still up 11%.

Commodity prices, which started to rebound a couple of weeks earlier, have had their biggest rise over an equivalent period since late 2010.

Traders talk of “risk on” times, and the past six weeks rank as one of the biggest risk-on rallies since the global financial crisis.

Yet the picture isn’t one of wild risk-taking, whatever the headlines appear to suggest. Three of the traditional safe assets to which investors fled in January and early February haven’t fallen back as risky assets gained.  The yen, gold and the Swiss franc remain elevated compared with the start of the year, and while they have fluctuated, they are almost as strong as on Feb. 11, the day equities and credit hit their trough.

This is unusual, to put it mildly. Safe assets normally move in the opposite direction to risky assets, as investors switch between fear and greed. U.S. Treasury bonds, another safe asset, have sold off, but by much less than risky assets rose. Yields on the 10-year bond, which rise as prices fall, are up 0.24 percentage point from their low, to 1.87%.

How do these signs of fear square with the stunning rise in equities and emerging markets? Put simply, this has been a misery bounce driven by stronger commodities. It isn’t a rebound to enthuse investors.

Worries have changed, rather than gone away. In February, investors feared recession, deflation, Chinese devaluation, falling profits, excessive emerging-market debt and corporate defaults due to cheap oil. More expensive oil assuaged some of these concerns and prompted a repricing of commodity-linked assets and of inflation-linked assets. That boosted emerging markets, junk bonds and mining stocks, while prompting a flood of cash out of money-market funds.

Consider mutual-fund flows. Cash has poured back into junk-bond funds, emerging-market equity and debt funds, and commodity funds, according to tracking by EPFR Global.

There were government-bond outflows, but almost all of it has been due to a rotation into equally safe inflation-linked government-bond funds.

Within the equity market, the safest, most boring utilities have led the market up. Smaller companies, which almost always outperform in a rising market, have done much less well than usual. The U.S. Russell 2000 index of smaller company shares still is down about 5% this year, even as larger companies stand pretty much where they started January.

Concerns also are evident in the options market, where traders can use put options to protect against share prices falling, or call options to profit from rising shares. The ratio between the two is often watched as a measure of speculators’ willingness to take risk—and indicates far more caution than usual.

The message from the markets is that investors don’t really believe in the rally.

This could be seen as great news for the contrarian. Markets climb a wall of worry, and there still are plenty of concerns out there that can be overcome, helping prices higher.

The best bets on this view are those that lagged behind during the rebound, such as financial or luxury-goods stocks—but given the fear, don’t expect a smooth ride.