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In January, I published my outlook for 2013, which argued for continued long positions in risk assets supported not by fundamentals but by lax monetary policy. As of the end of last week, we’ve ridden the ticker tape higher by +17.9% for the S&P 500 Index and high-yield trading below 5%. Naturally, having that many shiny new chips on the table means we need to start questioning when it’s time to fade the rally.

The search for yield has sent many bonds (including high yield) deep into above-par territory. (For high yield, that is especially notable.) Valuation metrics on equities look slightly more reasonable with the S&P trading at 15× forward earnings. Now for a normal market, that would be about middle of the road, but negative earnings guidance suggests the ratio is probably much higher than that. Yet the bulls remain firmly in control of the market because the Fed continues to control the money supply, and as long as it is injecting liquidity, the equity markets will remain the bond markets’ floodplain. I won’t bore you with another chart, but the link between QE and stock market returns is one that is universally acknowledged and has become an integral and powerful pricing tool for equities. Naturally, then, finding the inflection point for QE will mean finding the top for equities. Without QE, the fundamentals simply aren’t there.

But herein lies the rub: Higher asset prices create positive wealth effects, but at the same time, several governors, including Bernanke himself, recognize that their policies are creating asset bubbles. So the Fed is faced with the uncomfortable decision to tolerate asset inflation or stymie growth and employment. In the end, I think the Fed (led by Bernanke and soon by Yellen) will look the other way when it comes to asset bubbles as long as that asset inflation doesn’t make its way into consumer inflation. (The prognosis for inflation is actually quite good: The headline is below core, owing to the deflation happening in the commodity space; personal consumption expenditures, the Fed’s more favored inflation gauge, is hovering at just over 1%.) All that said, the Fed has already started to signal to the market that it is creating “exit strategies” for its bond-buying program as the United States has been making solid strides toward its recovery. Housing is now a positive contributor and in no small way played its part helping households recover all of the net equity lost during the crisis. Perhaps the most critical change, however, is the fact that money multipliers (via home equity and small business lending) are starting to work again. This means the Fed will grow increasingly cautious of all of that excess liquidity in the system.

Now, what’s interesting to me is the “surprise” selloff in gold this quarter. Part of it can be explained by strong technical selling following the fire sale by Cypress and big money managers (such as Paulson and Soros) trimming their positions. But I think the bullion market is registering something that the equity markets haven’t yet. Gold, like equities, has rallied tremendously over the last few years as an effective defense against the wholesale assault on fiat currencies. As such, the gold market may be one of the best barometers we have on the prognosis for QE. The fact that gold has struggled over the last few months tells me that the prospect for further easing (save for the Bank of Japan) is fading and rightly so; gold has taken a nosedive. The question is, When will equity traders wake up and smell that same wilting rose?

I think it’s important to note that I have not turned universally bearish on equities because the sad fact remains that there are no other real alternatives. But you cannot ignore the implications of Fed policy, the weaker earnings outlook, and the near uninterrupted upward march we’ve seen. All of these suggests to me that we may see more than just a pause in the coming months: After all, something’s gotta give.

One of the primary objectives of the Fed’s policy was to enable as many homeowners as possible to refinance into a lower mortgage rate. The Fed affected rates not only through its language and guidance but also through the outright purchase of agency mortgage-backed securities (MBS). Through the years, while the Fed has bought securities (as well as implemented such programs as the Home Affordable Refinance Program for the credit-impaired borrower to refinance), more and more homeowners have refinanced into a lower-cost mortgage.

As a result, the landscape of the MBS market has dramatically changed. Fewer bonds are available for investors to hold, with the Fed purchasing nearly two-thirds of all new issuances, and the new bonds outstanding in the market have lower coupons and greater extension risk. The investors still holding premium mortgages are facing headwinds from faster prepayments, which causes their bonds to be returned at par. The majority of 30-year agency MBS bonds outstanding trade at a premium of 5+ points (30-year threes at roughly 103, fives at roughly 108, and sixes at roughly 109); thus, prepayments returned at par have been a big hit to some bonds and have left investors with less income than they expected.

Given the “pain” that investors have endured through faster prepayments leading to lower yields, many have sought the refuge of lower premium bonds. Given the premiums where many mortgage coupon bonds are trading, most par-dollar-price bonds must be created synthetically. The way Wall Street can provide MBS bonds that trade closer to par is by “stripping” the coupons.  Investment banks’ structuring desks can satisfy the demand for mortgages with a price closer to par by, for example, taking a pool of mortgages with a coupon of 4% and creating a bond with a 1.5% coupon. They can then take the remaining 2.5% of coupon and create an interest-only (IO) security.

Investors looking to protect against rising rates have found buying IO bonds to be a viable option. In the fixed-income world, IO bonds are some of the few bonds that are truly “negative duration.” This means that they should appreciate in value as rates rise.  Because the holders of IO bonds receive just the interest portion of the mortgage, the bondholders would like prepayments to be as slow as possible so a greater amount of interest flows to them. As interest rates rise, prepayments should slow, and the investor should receive a greater amount of cash flows from the IO bond and thus higher yield. Agency mortgage derivatives, such as IO bonds, traditionally trade at higher option-adjusted spreads (OAS) because there are not natural buyers of the bonds, meaning there are not institutions with a natural asset-liability need for such a cash flow. Right now, it isn’t uncommon to see IO bonds trade at an OAS of 1,000 bps or more. As a refresher, the OAS is the additional spread after adjusting for the option value. This is the compensation that buyers, such as hedge funds, get for taking on the volatility of this IO bond.

In order for these IO bonds to be created, there has to be a buyer of the stripped down 1.5% collateralized mortgage obligation (CMO). Given the described state of the mortgage market, such institutions as banks, which have been burned on prepayments, have stepped in and created a huge demand for these “stripped-down” bonds. The stripped-down coupon bonds appease the banks (many of which have rules on maximum dollar prices for a purchase) with a stable yield profile as the bond trades at or close to par. With the OAS on the IO bonds trading around 1,000 bps or higher, the OAS on the stripped-down CMO is thus often negative. In short, I believe that the IO buyers are lucky to find a “sucker” to purchase the stripped-down CMO. What the buyers of the stripped-down coupon may or may not realize is that the convexity profile they now own is dramatically different from that of a fuller coupon bond. Should rates rise, the bond will have a much greater duration (price sensitivity) than other bonds. Thus, the investor has traded an arguably more favorable profile of yield/duration outcomes in other rate scenarios in order to have a more stable yield profile today. If rates remain low, the buyers of the bond will see their cash flows called away, while in a rising rate scenario, the bond’s duration rises rapidly because of the low coupon.

In contrast, the initial yield profile for the IO buyer can at times look pretty unappealing. Depending on the type of underlying collateral, a number of IO bonds can trade at negative yields based on current prepayment rates. It’s fair for someone to ask why an investor would purchase a bond with a negative current yield. The answer is that while it may incur negative income in the initial months, the investor is likely projecting slower prepayments in subsequent years, which can make the bond look very appealing — or just the opposite as the stripped-down buyer. As previously described, these bonds are typically purchased with huge OAS of more than 1,000 bps, thus substantially better relative valuation than the other bond.

Although one may be quick to conclude that the “smart money” is the IO buyer and the “dumb money” is the stripped-down buyer, the verdict will be decided based on the path of interest rates/prepayments going forward. In my opinion, the buyers of the IO are buying into a much better risk/reward as reflected by the initial OAS values. As various institutions continue to search for ways to hedge and speculate against rising interest rates, agency MBS derivatives should remain a popular option as long as structuring desks can pawn off the remaining bond on more unsophisticated buyers.

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The easy money has been made. I am not referring to picking the market bottom reached on May 9, 2009. That would have been speculation, not investment. In fact, just six months before I attended a conference where Emerson Chairman and CEO Dave Farr spent 10 minutes explaining that his cash and liquidity position could withstand a two-year depression with no profit. Every presenter who followed did likewise. I never want to see that again and neither do you. Many attendees, of course, are no longer in the business.

Stabilized conditions + Fire sale asset prices = Alpha. This sounds trite, but once conditions stabilized, easy pickings were available. Stability meant that (1) capital markets were functioning thanks to global government action, (2) unemployment had stopped rising, and (3) data points were improving (and “getting less bad” counts as improving). Fire sale prices to us mean big discounts on peak earnings. Leaving out “plunge” level lows — by the second half of 2009 the Lehman lesson had been painfully learned and governments were printing paper to prop up their banking systems and voter solvency but after that stock prices must climb a wall of worry. Generally speaking, they have. Next opportunity: end of the next recession.

Decelerating orders, revenue misses, and lowered guidance. Aside from that, first quarter results were fantastic. We remain in a moderate-growth global economy, which means moderate growth in demand for capital equipment. I see no significant change: We will continue to see one quarter slow followed by one quarter re-stock for some time as the United States, Europe, and Japan continue to work through high debt and graying populations. Governments, by and large, are doing about as well as can be expected in dealing with the twin urges of “spend less” and “spend more,” given the level of disagreement within their electorates, which amounts to a complete lack of consensus on almost anything. The United States is better positioned to recover sooner because residential real estate price improvement benefits employment, bank balance sheets, property taxes, and potentially even the immigration debate. China will grow, although slower than before and with a different focus than on exports.

Our macro outlook will be similar to others; where we differ is in how to play it. My firm collects, organizes, and analyzes data and information from 55 key global industrial companies across 10 key verticals and all major geographies, deriving deep granular insight. But to keep things simple, here is the thematic picture:

RESOURCES (Oil and Gas, Mining): Weak. The secular drivers are intact; the world wants more energy and hard commodities. Unfortunately, the capital investment party got out of hand and has led to overcapacity in both oil and gas (unused compressors on site in fracking areas) and mining equipment (layoffs and capital spending cuts) along with junior miners cutting projects and possibly reneging on taking deliveries). We believe that oil and gas will correct soon but that mining can — and likely will — get worse.

INFRASTRUCTURE (Power and Energy, Road, Rail, Marine): Long-cycle refining and chemical projects are progressing, which should be helpful beginning in the second half of 2013.

INDUSTRIALIZATION (Machinery, Automation, General Industrial): Machinery is generally weak outside of agriculture, but construction equipment inventory is working lower and comparisons get easier. Automation markets remain generally soft (a weak Europe means weak China exports, which means weak Chinese capital spending).

URBANIZATION (Construction, Consumer, Aviation): Improving. Residential construction is up (from a trough), the auto industry is stable, and aerospace build rates are increasing.

There are things to do, and there are things not to do. Patience, discipline, and common sense are key. I will be celebrating my 25th anniversary in the investment management industry on May 22. This means not only that I am getting older but also that I am starting to know what I am doing. Plenty of tread marks attest to those years. For all the supposed challenges of investing in a “global” world with “greater sophistication” and “high frequency” trading, I see the same (stupid) stuff happening — but faster. That’s fine with me. For example, from December 2012 to early February 2013, machinery stocks rallied strong in anticipation of a recovery in China and expectations of inventory drawdown for construction equipment. Why anyone thought a new regime in China could step into its new role, turn a key, and drive 10% GDP growth so that our stocks could go up is beyond me. And by early February, the market started to get the joke, pummeling the machinery sector right back down.

Things we like:

Bombardier (BBD.B TO): Investors need to own this. The company operates in two areas — commercial aerospace and passenger rail. Aerospace is what matters. BBD is migrating upward from its business/regional jet base and entering the narrow-body market with the CSeries. Investors get to play the aerospace cycle, share gain (CSeries), accelerating sales, margin and cash flow. Two near-term events should help: CSeries’s first flight by the end of June, the Paris Air Show in July. The first delivery takes place in 2014. As production ramps up, you get volume, leverage, and declining capital spending (to C$1 billion from C$2 billion by 2015). Where can the shares go? Our 3–5 year view is C$10–17 in 3–5 years depending on whether you wish to use happy juice or realistic scenarios. In the next 12–18 months, we see C$7 as very realistic, and it has been there in the last two years.

Caterpillar (CAT): We turned cautious in mid-2012 as construction began to roll over and guidance started coming down. Until recently, we remained on the sidelines, even as CAT caught a bid and ran up by 20% off its December low to the beginning of February on everything except actual fundamentals. The stock is now attractive in the sub-$90 area. Downside is 10 points to about $80, upside to $100 (firm) and possibly $115 (it’s been there twice over the past two years). While mining remains a mess, and will for longer than most people think, the company is still predominantly construction, and that piece is set to improve as excess inventory is worked down and production levels rise. Any time I get a 2:1 up to down ratio and fundamentals getting ready to turn in my favor, I want to buy.

Things we don’t like:

Eggplant, property taxes, and traffic jams. With respect to stocks:

Xylem (XYL): Water infrastructure (pumps, treatment, testing). Fairly valued stock (over 9 times EBITDA) with no growth because the customer is either broke (municipalities = 36% of sales) or not spending (industrial = 40% of total).

SPX Corporation (SPW): Frustrating stock. Trading around $75. Upside to $100+ on a breakup; recent involvement of Relational Investors has dramatically improved the capital allocation profile, which means they have to put a stop to management destroying shareholder value by overpaying for deals. Bad news — the breakup value is contingent on several things, including thermal being monetized (not currently possible), transformer recovery (happening, but takes time), and better execution.

Industrial automation names in general (fair value, weak growth): ROK, EMR, and ABB.

We encourage you to visit our website www.langenberg-llc.com, and you should follow us on twitter here.

Linkfest.com finds today’s top headlines by following the best ‘curators’ on the Web and on Twitter, and by your votes and social media shares – pick the most important stories you think should appear by voting here.