Bond Markets Will Pull Equity Markets Higher

The weakness in equity markets as of late has been rather strange.

It has not been accompanied by weakness in the risky areas of each asset class and it has not been accompanied by a blow out in "risk indices". Usually weakness in the major market equity indices (like the Dow and S&P 500) is either accompanied by or preceded by significant risk aversion behavior.

How do we measure risk aversion behavior (or at least the mood of the market)? We use risk indices. A good indicator of the mood of the market is the Bloomberg Financial Conditions Index. In essence it is comprised of yield spreads from the Money Markets, Equity Markets, and Bond Markets and expressed as a normalized index. The values of this index are z-scores, which represent the number of standard deviations that current financial conditions lie above or below the average of the 1992-June 2008 period.

The failure of the Bloomberg Financial Conditions index to break down (so far at least) is largely a result of the bullish behavior of bond and money markets. For whatever reason, high risk junk bonds and emerging market sovereign debt remains reasonably strong.

Given the degree to which the Dow Industrial and Dow World Index have fallen over the last 6 weeks one would have thought that junk bonds and emerging market debt funds would have already fallen materially.

There is a clear non confirmation of the weakness in equity markets by corporate and emerging market bonds. So will bond markets remain strong and pull equities higher or at least ensure that any downside in equities is limited? Or will the weakness in equity markets spillover into corporate and emerging market bond markets pulling them lower?

Our money is on the former. We think that the weakness in equity markets as of late is a "false move" and that it is unlikely that there will be material downside in the major market indices.

Accordingly, here at The Daily Trading Report, our call is that one should be looking at buying into weakness rather than selling.

Disclosure: The Daily Trading Report holds no positions in assets mentioned in this article.