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In a previous article, I looked at the disconnect between stocks and bonds. This article is examining the sterling performance of bonds exceeding their October highs, while the stock market, although weakened, remains well above its 2011 lows. This divergence is seen in the chart below:

(click to enlarge)

From October to April, the S&P 500 (NYSEARCA:SPY) impressively climbed from its low of 1075 to a high of 1425. Despite this strong move, the bond market (NYSEARCA:TLT) remained range bound with yields between 2.5% and 1.8% on the 10 year note.

In retrospect, this was a clear warning sign that the bond market was not a believer in the stock market's optimism. Now, as the S&P 500 has fallen from 1425 to 1278, corresponding to 128 on the SPDR S&P 500 ETF, yields have fallen to 1.47% on the 10 year note.

This certainly is due in large parts to European fears and potential contagion. The fear in the markets is palpable and evident in many measures. However, I think the low bond yields are the most prominent example.

Historically, at a 3% yield, the 10 year note is forecasting no inflation, at today's yields, negative inflation is being implied. Regardless, it is clear that many are more concerned with return of capital rather than return on capital.

I will examine similar extreme moves in bonds in the last 12 years and see what it has meant previously for S&P500 direction - short term, intermediate term, and long term. I am defining an extreme move by when yields hit 75% of its 200 Day Moving Average. My hypothesis is that in the short term, this development results in turbulence but longer term, returns are positive.

September 2002

10 Year YieldS&P500
STARTING POINT3.60%820
1 Month Later4.20%881
3 Months Later3.90%890
6 Months Later4.03%868
1 Year Later4.21%1022

January 2008

10 Year YieldS&P500
STARTING POINT3.43%1338
1 Month Later3.91%1366
3 Months Later3.73%1388
6 Months Later4.15%1286
1 Year Later2.62%830

December 2008

10 Year YieldS&P500
STARTING POINT2.70%841
1 Month Later2.42%937
3 Months Later2.92%699
6 Months Later3.65%946
1 Year Later3.32%1111

Conclusion

I did not think this effort would yield a great timing tool but a more general measure of risk on versus risk off. My definition for extreme turned out to be quite apt as despite the volatility of the last 12 years, these conditions were generated only 3 times.

Each instance of this "extreme" move occurring provided a buying opportunity, as some money moved out of bonds and into stocks. However, there is no clear sign, longer term, whether the buying turned out to be a corrective nature or a more secular nature.

Overall, this measure is a useful indicator to step back on bearish bets in the short term. Even recently, this has proved prescient as the recent extreme reading in bonds has led to a rebound in equity prices and a fall in bond prices.

Source: S&P 500 Bottoms And Bond Market Tops