INVESTORS FAVOR BONDS OVER STOCKS DURING 2012 -- CORPORATE BONDS AND TIPS ARE DOING BETTER THAN TREASURIES -- INVESTORS FAVOR CORPORATE BONDS WHEN STOCKS ARE RISING -- QUANTITATIVE EASING HAS ALTERED BOND-STOCK RELATIONSHIP
INVESTORS STILL PREFER BONDS OVER STOCKS... Despite the fact that U.S. stocks have done much better than bonds during 2012, investors still prefer bonds. Mutual fund money flows show that investors have pulled money out of stocks funds and put money into bond funds. That may seem strange considering that the S&P 500's 14% gain has outpaced bond gains. A lot of that may be the result of Fed policy, which we'll come back to later. When examining the bond (fixed income) market, It's important to recognize that their are several bond categories. Chart 1 shows the 20+Year Treasury Bond iShares (TLT) gaining 4% for the year, but well off its July high. That has been the worst performing bond category for the year. The Correlation Coefficient (below chart) also shows a negative correlation of -.87 with the S&P 500. Chart 2 shows the TIPS Bond IShares (TIP) trading near a new high for the year ( and up +6% for the year). TIPS are a hedge against inflation and jumped sharply on the launch of QE3. Corporate bonds have done even better. Chart 3 shows Investment Grade Corporate Bond iShares (LQD) trading well into new highs. The LQD is the best performing bond category this year with a gain of 10%. It also has a stronger correlation to stocks at .49. Chart 4 shows High Yield Corporate Bond iShares (HYG) dropping to its 50-day average. It had been the bond leader until mid-September when launch of QE3 caused some profit-taking. That may suggest that investors have turned a bit more cautious since QE3 which may carry a short-term warning for stocks. That's because the HYG has the highest correlation (.93) to stocks.
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Chart 1
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Chart 2
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Chart 3
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Chart 4
INVESTORS PREFER CORPORATE BONDS WHEN STOCKS RISE... Since bond categories offer different degrees of risk, one way to measure investor confidence it to measure the relative performance of bond categories. The green line in Chart 8 plots a "ratio" of Investment Grade iShares (LQD) to Treasury Bond iShares (TLT). That ratio tell us which of those two bond categories investors favor at any given time. A rising LQD/TLT ratio usually coincides with a rising stock market. The blue line compares the S&P 500 to the bond ratio over the last three years. Notice that they tend to rise and fall together. They rose together during 2010, fell together during 2011, and have been risen during 2012. A rising ratio shows that investors favor corporates over Treasuries which shows more confidence. Corporate bonds are more dependent on the strength of corporations that issue them. The LQD/TLT ratio bottomed during the fourth quarter of 2011 and again this summer (up arrows). That suggests that most of the bond money is flowing into corporate bonds. That's a conservative way for bond investors to assume more risk without having to buy stocks. Another useful ratio divides high yield (HYG) by investment grade corporates (LQD). That's the green line in Chart 6 (HYG:LQD). A rising ratio suggests that investors are willing to assume even more risk buy buying high yield bonds in the search for higher yield. The HYG:LQD ratio generally rises along with stocks (blue line) as they've been doing all year. The sharp drop in the ratio since mid-September, however, (yellow area) suggests a defensive rotation in the fixed income space. It remains to be seen if that has a negative impact on stock prices.
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Chart 5
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Chart 6
QUANTITATIVE EASING ALTERS BOND-STOCK LINK... Deflation over the last decade has caused bond and stock prices to trend in opposite directions. Although that inverse link hasn't disappeared, it isn't as strong as it used to be. That's largely due to the actions of the Fed. Chart 7 compares the S&P 500 (blue line) to the price of the ten-year Treasury note since 2000. Bond and stock prices trended in opposite directions from 2000 until the start of 2010. That inverse relationship is confirmed by the negative Correlation Coefficient below the chart. The correlation line started rising in late 2010 and turned positive late last year. I believe that to be the result of Fed policy. The vertical lines identify the launch of QE1 and QE2. The third line marks the start of Operation Twist when the Fed sold short-term debt to buy longer dated bonds. Bond and stock prices have risen together since then. Part of the Fed policy of driving bond yields to historic lows has been to drive investors into higher-yielding assets, which include stocks and higher yielding corporate bonds. That policy appears to have worked. Most of the money, however, is staying in the bond space. I suspect part of the reason for that is investor skepticism of stock gains that are inspired more by Fed intervention that actual economic strength. A second preference for bonds is the Fed guarantee that bond yields will stay low and bond prices high. In that sense, Fed policy seems self-defeating. By keeping bond yields low, the Fed is keeping bond prices high. As a result, there's no great incentive for bond investors to take chances with stocks. Here's a thought. By keeping bond yields low (and bond prices high), the Fed may actually be preventing a normal rotation out of bonds and into stocks.
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Chart 7
SOME BOND MONEY IS MOVING INTO DIVIDEND STOCKS... Some of the bond money is going into large, dividend-paying stocks. Chart 8 shows that clearly. The black line is a "ratio" of Dividend iShares (DVY) divided by the S&P 500. The green line is the yield on the 10-Year Treasury note. Notice that every drop in the bond yield over the last four years (down arrows) has coincided with an upturn in the DVY/SPX ratio (up arrows). That makes a lot of sense. When bond yields drop, conservative investors have to search for yield elsewhere. Dividend paying stocks are one way to do that. That also offers bond holders a more conservative way to enter the stock market. The fact that dividend paying stocks are usually larger stocks with defensive characteristics (consumer staples, healthcare, and utilities) offers even greater protection against market downturns.
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Chart 8
FALLING BOND YIELD WEIGHS ON STOCKS... Although the intermarket link between bond yields and stocks has weakened, it hasn't disappeared. Chart 9 compares the 10-Year T-Note yield (green line) to the S&P 500 since January. The chart shows that stocks generally do better when the bond yield is bouncing. A falling yield (like during March) has often led to a stock correction. I point that out because the summer bounce in the bond yield peaked in mid-September and is dropping. If the bond yield drops much further, that may prompt some short-term profit-taking in stocks.
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Chart 9
OVERBOUGHT S&P 500 LOOKS VULNERABLE TO PROFIT-TAKING... Chart 10 shows the S&P 500 still in an uptrend, but slipping a bit since mid-September. Its RSI line (above chart) peaked in overbought territory over 70 a couple of weeks back and it testing its midpoint at 50. A drop below 50 would signal more selling. The 12-day Rate of Change (ROC) line below the chart also shows weakening in the market's short-term momentum (see circle). If the S&P does sell off, the first line of support to watch is its 50-day average (blue arrow) and the summer highs in the 1422-1415 range (shaded area). Prices would have dip below those levels to signal a more serious correction.
