Picture du Jour: Watch the stock/bond ratio

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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 US 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.


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

Although I am of the opinion that US 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.

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8 comments to Picture du Jour: Watch the stock/bond ratio

  • Watch the stock/bond ratio for direction of markets…

    Is the worst of the credit crisis behind us? The short answer is that nobody actually knows. However, the so-called stock/bond ratio serves a useful purpose of indicating to what extent safe-haven buying of bonds as opposed to stocks is taking place, i…

  • richard warren

    I don’t know if I’m early…or stupid…but starting in February, I’ve moved funds from bonds to money market (on the assumption my bond funds will soon suffer large losses as rates move higher to counter inflation and growth). Of course I’m also redeploying those money market funds to equities as opportunities arise.

  • Mr. Obvious

    I don’t think much of trendlines constructed with only two contact points and was ready to mention that as a reason to ignore the chart. When I recontructed the graph on the Bloomberg terminal, however, there were three definite contact points. (I created a relative strength chart of UST4GP v. SPX ). I’d watch for the ratio to start taking out (or NOT take out) previous highs, like the one near the end of February, for further clues.

  • Mr Obvious: Good to see you visiting again. I agree that the previous high is of great importance. (I didn’t refer to the trendline break in my text for the specific reason that I didn’t think it was particularly significant.) But I will always read this together with measures such as spreads and other risk parameters that are very relevant to the stock/bond debate.

  • Sugam

    The VIX has broken through the 200 day average and the Dow Jones Transportation seems to be rallying with their 200 day moving average turning flat ( from a previous negative trend ) …. It feels like rally ( maybe short ) is on cards? Any comments on Transportation average?

  • The current drop should take us back to just above 11,700 on the Dow and could conceivably drop below that. Until then shorts are the name of the game. Once we complete, can we begin to rise in earnest.


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  • Sugam: Regarding the DJ Transportation Average, the following article by David Gaffen appeared in the Journal on April 1:

    “If conventional wisdom – and a mountain of economic data – suggest that the US economy is falling into, if not already in, a recession, why are the transportation stocks doing so well?

    “Investors often look at transportation stocks as a bellwether for the economic outlook. Transportation, in one way or another, is an integral part of many major industries; if manufacturers are seeing slack demand, they will ship fewer goods.

    “However, through Friday, the Dow Jones Transportation Average has gained 4% on the year, hardly an indication of a dire economic situation, while the Dow Jones Industrial Average is down 7.9% and the broader Standard & Poor’s 500-stock index is off by 10%.

    “‘It’s a very interesting contradiction, because here we are in what most people think is going to be an extended economic slowdown and yet we have much better action, certainly among the truckers and railroads, than one would expect,’ said Kenneth Tower, chief market strategist at Covered Bridge Tactical.

    “Since the stock market is a predictor – not always correctly – of growth, the rally in transportation stocks reflects expectations of a rebound in economic growth later in the year, just as it fore-shadowed the decline in late 2007.

    “What strikes some as odd about the rally is that transportation companies still face significant head winds, particularly from energy costs. High fuel costs cut into the profitability of airlines and shippers such as FedEx and UPS. But perhaps this has been factored in, both by shippers and investors. The American Trucking Associations’ truck-tonnage index was up 3.5% in February from a year earlier, suggesting a rebound from economic weakness.”

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