Keep an Eye on the Stock/Bond Ratio

Is the worst of the credit crisis behind us? Some of my perma-bear friends will probably think of hospitalizing me for merely raising the question. The short answer, however, is that nobody actually knows. Sure, one can deliberate the fallout of the subprime saga to the nth degree, but even a crystal ball regarding the economic variables doesn’t necessarily mean getting the markets right.

In muddled times such as these it is often helpful to keep things truly simple. And seeing that these posts are styled as “Picture du Jour,” I am in any event supposed to deal only with a single graph (plus maybe one or two complementary ones).

The graph in question is the so-called stock/bond ratio that serves the useful purpose of indicating to what extent safe-haven buying of bonds as opposed to stocks is taking place. This is a price-relative chart, meaning it is calculated by dividing one time series by another in order to ascertain relative out- or underperformance. In this instance the comparison is between stocks (using the S&P 500 Index as proxy) and government bonds (using the U.S. 10-year Treasury Note) as illustrated by the monthly graph below.

Source: StockCharts.com

The price relative (blue line in the top section of the diagram) clearly demonstrates how bonds have outperformed stocks over two distinct periods, namely from the middle of 2000 until the middle of 2002, and from the middle of last year until recently. Studying the raw data, the periods of under-/outperformance of stocks (red line) and bonds (green line) can be seen clearly.

Let’s now zero in on movements over the past few weeks by looking at a daily chart:

Source: StockCharts.com

The blue relative line reveals how stocks have started outperforming bonds from the middle of March (with stocks moving higher and bond prices declining) as risk aversion has started becoming less pronounced. Are we seeing a turning point of any importance, especially as we have been “fooled” by a few false spikes in the blue line over the past few months?

In my opinion it is too early to draw specific conclusions. There are, however, a number of pointers one should be cognizant of in trying to assess the situation, including the following:

The spread between the Fed funds rate and two-year Treasury Note yield is now 35-basis points, the lowest level since July 2007 (see graph below).

The CBOE Volatility [VIX] Index has dropped from 32% to 23% and is threatening to break its 200-day moving average (i.e. bullish for stocks).

Credit Default Swap [CDS] spreads have narrowed.

click to enlarge

Source: GaveKal – Checking the Boxes, April 3, 2008.

Although I am of the opinion that U.S. long-dated bonds are topping out (see post “US Long Bonds in Injury Time” of March 28, 2008), I still can’t get excited about the prospects for the stock market beyond an intermediate rally, especially given a rather sombre earnings outlook and still relatively high valuation levels.

The stock/bond ratio may very well have some further backing and filling to do before registering an “all clear” turning point. But let’s closely watch the spreads and other risk parameters, and keep an open mind about interpreting the language of the market.

Comments

[300mph]

If I read one more article about how 'the market may or may not be turning', may be 'going up or down from here' ,but 'we will just have to wait until it's over to be sure', my head is going to explode.

Come on, people! Be bold, take a stand for once in your life.

[Jan Sopoci]

300 MPH,

I always figured the point of reading these things was to extract the info (if any), and come to my own conclusion, then act accordingly. (FWIW, I'm nibbling a bit, but still keeping some powder dry).

Jan

[Jeremy Elliott]

I value an unbiased presentation of data when the impetus of the article claims to be as such. When I want someone to tell me it's all clear to pull the trigger, I pay 2.7% APR on my total account equity to listen to my professional broker tell me what to buy.

[engineer1]

Buy really really low and sell really really high.... now you have been told what to do. JJ