Bonds Should Continue to Outperform

Despite their strong rise over the second half of 2007, technically, some interesting things have been happening in the world of bonds: the S&P 500 is exhibiting glaring weakness against the 13 week T-bill index (a decent money market proxy) and the Shearson Lehman Aggregate bond fund (AGG).

This is the first time since 2003 that I have seen short term bonds reverse up so strongly versus these two benchmarks. This means that on a short term basis, their recent strength notwithstanding and despite our firm's own official recommended bond allocation of only 12% in benchmark portfolios (10% is the lowest we'll go), bonds amazingly seem to have a good chance of outperforming stocks for a while to come.

This particular indicator has signaled trouble in the past. Indeed, prior to the last three major market declines, my money market proxy reversed back into a column of X's (a sign of technical strength) to suggest that there was likely to be continued turmoil in the equities market. For instance, in 2000 this relative strength chart reversed up by April, suggesting investors should raise cash levels.

Another noteworthy signal came in April 2002, when the money market proxy reversed up and remained in X's until the end of July of 2002. That April 2002 signal would have helped an investor take some chips off the table in front of a near 16% correction in the S&P 500.

And it makes sense today on a short-term basis: as economic numbers continue to sag, investor anxiety levels will likely rise, expectations for more interest rate cuts from the Federal Reserve will increase and stock market participants may rush further for the high ground of bond market safety.

I actually believe that most longer-term equity market risk was wrung out of U.S. stocks in the second half of last year, but there does appear to be some more downside potential from here and it could be quite swift and scary. Despite the fact that I expect any such sell-off to yield excellent stock buying opportunities, this morning's bond market rally in reaction to more weak economic data should not be too surprising.

In fact, increasing investor fear could keep the seemingly unattractive bond market rallying throughout the first quarter of 2008.

Disclosure: none