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Barron's publishes a ratio that it calls a "Confidence Index." The Confidence Index is derived by dividing Barron's index of Best Grade (corporate) Bonds by Barron's index of Intermediate Grade (corporate) Bonds. According to this paper, if the intermediate grade index falls relative to the best grade index, it represents a sign of market confidence because the intermediate grade bonds are not requiring as much of a yield spread as in the past and this means that investors are more confident. The paper suggests that this "generally indicates rising confidence, pointing to higher stocks."

Well, Barron's Confidence Index hit a near term low in the week ending July 27 and has been rising since. The implication of this movement is that, potentially, the stock market should rise. Note: One can use the yields on Moody's Aaa- and-Baa rated industrial bonds published in Federal Reserve release H.15 and get a similar result.

Since August 3 the Standard & Poor's 500 Index has risen about 2 percent from 1390 to 1418.

Defining the confidence index in this way makes some sense since when financial market conditions are improving the yield on intermediate grade bonds tend to fall faster than does the yield on the best grade bonds causing the confidence index to rise.

Conversely, when confidence is being lost in the bond markets, yields on intermediate grade bonds rise faster than do the yields on the best grade bonds. This is what happens in a "normal" cyclical situation. However, the past several months have not been normal.

Barron's Confidence Index has been rising because the yield on the Best Grade Bonds has been rising relatively more rapidly than the yield on Intermediate Grade Bonds. This is also true of the movement in the yields on Moody's Aaa- and Baa-rated bonds. This is not the way it is supposed to be.

The difference is the fact that the United States bond markets have been a "safe haven" for funds from around the world. The flow of funds into United States markets have distorted interest rate relationships. The question is…does this distort the interpretation one gives to Barron's Confidence Index?

The international money really started pouring into the United States in early May. The yield on the 10-year Treasury issue broke 1.90 percent on May 8. Barron's confidence index reached a near term high in the week ending May 25. Moody's numbers actually achieved the near term high in the week ending May 5. Both measures of "confidence" fell until the week ending July 27 as mentioned above.

In this case, the confidence index fell because of all the foreign money flowing into the United States to seek the "safe haven". Yields on U.S. Treasury securities fell very rapidly, but also the best grade of corporate bonds also gathered in some of these funds and the yields on the best grade of bonds fell relative to the yields on intermediate grade bonds.

Confidence in the United States bond market was increasing while Barron's Confidence Index was showing a loss in market confidence.

The stock market dropped off soon after this "fall in confidence" with the S&P 500 index dropping off from about 1360 on May 8 and reaching a trough of approximately 1280 at the end of May. However, as related earlier, the S&P 500 was around 1390 by the first part of August, a rise of slightly more than 8.5 percent. The rise from May 8 to August 3 was a little more than 2 percent.

The argument for the immediate decline in the stock market in May was the fear connected with the deteriorating situation in Europe. After the initial decline in the stock market, "confidence" in the U.S. stock market seemingly came back, although the variation in stock market movements seemed to be rather high indicating the uncertainty connected with what was happening in Europe.

So, when Barron's Confidence Index dropped off in May the stock market also fell. From the end of May through the end of July, Barron's Confidence Index continued to fall while the stock market rose. So, we have some conflict here.

Another ratio using similar data can also be used in situations like this. It is called the "Liquidity Ratio" calculated by dividing the yield on 10-year U.S. Treasury bonds by the yield on Moody's Aaa industrial bonds. A higher ratio shows that the financial markets are "more liquid" since the ratio of yields is narrower. Funds are getting into the Aaa market as well as into the government market.

The "liquidity ratio" peaked out this year in the same week as did the "confidence index" using Moody's numbers. However, the "liquidity ratio" hit a bottom around the same time that the S&P 500 index was hitting the near term bottom in late May. This would indicate that some of the "safe haven" funds coming into the Treasury market began to spill over into the high grade corporate bond market. The financial markets were becoming "more liquid" due to the funds attempting to achieve higher yields without much loss of quality.

Thus, the stock market began to rise again in June as confidence rose on the "liquidity" of the financial markets, even though the liquidity had not flowed as far as the intermediate grade instruments. It was not until late July that more and more funds moved into Baa or intermediated grade bonds and Barron's Confidence Index started to rise again, along with Moody's numbers.

The "liquidity ratio continued to rise through to the present so that for the last several weeks we have had both the "confidence index" and the "liquidity index" giving off similar signs. Note, however, that the yield on the 10-year Treasury yield has been rising over the same time period, reaching its lowest level on July 25…1.43 percent. Currently, the 10-year Treasury is yielding over 1.80 percent.

The last several months, therefore, have been an interesting time period. The movement of international funds into the United States has caused some financial market relationships to be distorted. Still, it is important to work with the data and see if events can be explained by including more information in one's analysis. Historically, the "confidence index" information has moved in the same direction as the "liquidity index" information. When they differ it is important to try and reconcile why they might be moving in different directions. In the current situation, I believe that looking at the two ratios helps us to understand a little bit better what has been going on.

Right now, the bond markets are reflecting market confidence and market liquidity, both of which are positive signs for a rising stock market.

Disclosure: No positions

Source: Is the Bond Market Showing Confidence These Days?