The Relationship Between Stocks and Bonds: What Just Happened?

Includes: IEF, SPY
by: Paul Hanly

What just happened?

Over a period of about 3 months, the relationship between stocks and bonds has gone off the chart (literally, if you are more concerned with the "modern period" from 1960 - after the depressions and world wars ended).

click charts for larger, more readable images

10 year US Treasurys inverse yield divided by S&P PEClick to enlarge

I've used Shiller's spreadsheet (thanks for a great resource!) and plugged the following numbers for the last 3 three months. Earnings are probably less than S&P estimates.

Assumptions made for last 3 months

I calculated the inverse of the 10 year bond rate, then divided it by the S&P 500 PE calculated from the same spreadsheet. As bond yields just fell from 3.9 to 3.2%, earnings have recovered and we have had a fall in stock prices, we have seen a dramatic change in relativity of the earnings from stocks compared to 10 year bonds.

So what doesn't the market trust?

Bond rates have to go back up because of the risk of inflation? They didn't in Japan, where rates have been under 4% for 15 years. If we have tight fiscal policy to reduce sovereign debt ratios, then monetary policy is likely to be very easy as demand and jobs are lost because of tight fiscal policy.

Earnings are going significantly to fall because of the onset of austerity as stimulus fades and the budget hawks win influence? The analysts don't think so.

Or are we reverting to the preferences of earlier times because the boomers, who just can't cope with the thought of more losses in the value of their retirement funds, have switched to a preference for bonds?

This is what the relativity has been like since 1871. The incredible preference for bonds during the Great Depression and the world wars - and through to the 60's - is very clear in the chart below.

10 year US Treasury inverse yields compared to S&P PEClick to enlarge

The dramatic difference is shown by looking at where we are today in terms of the percentiles of the ratio over the two different time periods.

Looking only at the modern period, there has never been a better time to buy shares. In fact, the current value of 1.96 is the highest score since 1969.

Looking at the whole period covered by Shiller's data , we are about average, but a bit above the median.

Treasury Vs Stocks PercentilesClick to enlarge

Is this part of the "new normal", does something have to give, or did it just give?

Disclosure: 30% in stock market through emerging, commodity, Australian and international funds, 70% mixed bonds (plus Australian real estate exposure)