If you want to know where stocks will go over the next several months… look to bonds. These markets are intimately linked. Moves in one (bonds) foretell moves in the other (stocks).
This is inter-market analysis, a must-have tool in any serious analyst’s war chest. The global economy and international markets are closely linked. That’s why the relative performance of major asset classes becomes as important, if not more important, than the absolute moves made in each individual asset.
Traditionally, bonds and stocks have moved in sync with one another. Stocks have typically outperformed bonds in strong economies, while bonds win out in weaker ones. But generally, when bonds are up, so too are stocks.
This relationship, however, only held true for inflationary and disinflationary environments. Deflation is a whole other beast – one that pulls bonds and stock in opposite directions.
Take a look at the major divergence that began in 2008 as the equity market was cracking lower.
As you can see, scared investors hid in the relative safety of 30-year U.S. Treasury bonds as the Dow Jones Industrial Average lost 54% of its value through March 2009.
The relative strength comparison of bonds/stocks is much more telling. Take a look…
On top is the Dow Jones (10% drops shown by yellow dots; 20%+ drops by red dots), with a ratio of bonds/stocks shown on the bottom. The ratio is colored green when bonds are outperforming stocks and red when stocks are beating bonds.
(This ratio is extremely useful in forecasting stock market drops.)
On the ratio chart, I’ve drawn boxes around the periods in which bonds began to outperform stocks… in other words, when investors were jumping into bonds, and out of stocks.
These periods seem to come several weeks BEFORE stock prices actually begin to drop, giving investors adequate warning to move out of equities and into cash or bonds.
So what are bonds saying now about the future of stocks?
Bond prices peaked in mid-November. This was perfectly timed with a bottom in stocks, which have moved 15% higher since then.
Taken together – falling bonds and rising stocks – the bond/stock ratio line has been declining, and is well below its 50-day average for all of 2013.
This is a bullish sign for stocks.
I’ll be watching this inter-market relationship closely for any clear warning signals that the equity markets are about to weaken. I’ll know it’s coming because we’ll see the bond/stocks ratio start to trend higher and eventually hop over its 50-day average.
For now though, it’s business as usual with stocks still looking strong and bonds out of favor. So don’t listen to all the pundits’ calls for a correction in the immediate future. We still have some room to the upside.
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