Bonds, Large Caps to Outperform from Here?

Roger Nusbaum submits: I read an interesting article by Martin Pring on RealMoney.com about the ratio of stocks, as measured by the iShares S&P 1500 Composite Index Fund (ISI), and bonds, as measured by iShares Lehman 20+ year Treasury Bond Fund (TLT).

Martin provides different charts that are longer term but difficult to see in his article. This chart shows stocks generally being favored over bonds until April of this year when a down trend started (click to enlarge):

The long story short is that this ratio is coming to a critical point and while he does not believe in jumping the gun with any trades he believes that the ratio is about to signal that bonds will outperform stocks. Specifically, the signal is that bonds outperform -- it does not have to mean stocks go down, but the history of this, he says, is that equities do in fact weaken when this is triggered.

He says the key number of this ratio which he says is derived by dividing the S&P 1500 composite index (^SPSUPX on Yahoo) by the price of TLT. He says a break below 14.5 is the trigger.

I have to say his numbers are confusing to me. It looks like the actual index closed on Tuesday at 300.34, the underlying ETF (ISI) closed at $118.40 and TLT closed at 89.15. Dividing TLT into either the index or ISI gives a much different number than the 14.5 he notes.

While I am no doubt missing something, the concept is clear and makes some sense. In the last few months money has been rotating into bonds. If you think about how far yields have fallen this should not be a shock. A negative on the chart I have posted here shows the 50 DMA (the faster average) going below the 200 DMA (the slower average) in early September. The faster going below the slower is generally bearish for the thing being charted.

Per the article, this is a compelling indicator, but I did not see where it gives an indication of how long this indicator leads the market's direction. This sort of rotation is important in terms of bigger macro shifts in the market and worth watching.

This second chart illustrates something Barry Ritholtz touched on a few weeks ago. Money has been rotating out of small cap in favor of mega cap stocks, which is typically a late cycle event.

So following the money -- bonds looking better than stocks, and the money still in stocks is large cap over small; a risk aversion of sorts.

Stocks could continue higher, and no doubt there will be a comment or two saying there is a lot of bull market left and that could be, but don't lose sight of what could go wrong.

Comments

[CrossProfit_:]

More than a cap rotation there is more of a sector rotation in progress. If you have figures that show a small cap rotation we would like to see them. Sideline money is now first being applied to mega cap before EOY. This is not a rotation in our opinion.

CrossProfit
www.crossprofit.com

2006 Oct 05 04:59 PM

[Tom Kasperski:]

I think Roger's assessment is pretty spot on, but given where we are in the cycle, we should start to see evidence of growth outperforming value too. That's a more interesting story given the dominance of value stocks over the past few years.

There has also been relative performance shift away from internationals, particularly emerging markets over the past five months. Again, I think this is more evidence that risk aversion strategies are in play.

2006 Oct 05 06:08 PM

[fari nigiv:]

graphs do not open in seekingalpha - they show up in every other application

2006 Oct 14 04:48 AM