Over the last ten years or for that matter, the last thirty, bonds have been rallying. For reasons that we all understand, lower yields have generated higher stock prices. This should be true since it is a sign of falling inflation and easy money which is good for economic growth. We can separate out the effect on a short term basis to study how dependent we are on bonds. We need to know this because if/when bonds fall in price we (stock market portfolio managers) must be prepared. We can also use the information to become more aggressive at the right time.
Let’s Play a Game
To start I’m going to be rather dim witted and just buy the S&P 500 when monthly US 10-year futures price momentum is positive. You get to hold the S&P when it is negative.
I do much better than you but most of the spread is made during the Quantitative Easing period, when the Fed was buying bonds to save us from deflationary forces. If I go back 20 years I make 884 points and you make 70 but again almost all that spread is earned after 2011.
The problem is that in the short term bonds fall when stocks rise. That means that in my study I am simply buying stocks when they fall which works because we are in a great big bull market but I wouldn’t count on this working in a bear market. In 2008-’09 it provided no advantage at all and in the bear market of 2002 I would have gotten crushed to death.
Surely this won’t work.
What if we wait a week? If we do, we will allow for the time it might take for investors to shift money out of lower yielding bonds into equities. Yes, this seems very inefficient and a believer in EMH would never accept that it would make a difference. Here’s the result:
So now I make 1332 points and you lose 357 points! (This covers my entire 20 year period.) What we see is that big declines in the S&P are buffered if bonds have been rallying before the decline. It’s like wearing a protective suit, you can’t get hurt if yields were falling – a week ago.
Now Let’s Add a Little Fear
My previous article looked at how we need to buy the stock market when fear is up. Let me take the Vix index I referred to in that essay, and fix it by substituting a function that sets the low end of its range to zero. It looks like this:
You can see how readings below 1 are so low that we simply don’t need to own stocks at those times – everyone is fearless. We can then add that filter so now we must see bonds rallying (5 days ago) and some amount of fear must exist. I shall make no effort here to select a “good” fear level. When I do this, we will get fewer trades but we should get better entries than when we used only the bond filter. Here’s how it looks:
The 2002 bear market
This was a case where the plunging tech stock market was impervious to the bond rally and the S&P had bigger weights in that area back then. We must be sensitive to such conditions going forward in case they (once again), weaken the bond market’s impact. I believe it’s safe to say that the Fed is very sensitive to the current low inflation conditions and are perhaps too inclined to ease rates to save the stock market. When you allow for QE in Europe and Japan, it’s safe to say that this interest rate connection should remain intact for the foreseeable future.