RATIO ANALYSIS SHOWS A MAJOR SHIFT OUT OF STOCKS AND INTO BONDS -- ALL BOND CATEGORIES OUTPERFORMED STOCKS SINCE OCTOBER -- TREASURIES ARE DOING BETTER THAN INVESTMENT GRADE CORPORATES -- WHILE HIGH YIELD JUNK BONDS ARE THE WEAKEST BOND CATEGORY

COMPARISON OF TWO VANGUARD FUNDS SHOWS BONDS IN THE LEAD ... In good times when investors are confident about the economy, they usually favor stocks over bonds. One of the ways we can tell when investors are starting to lose confidence is when they start favoring bond holdings over stocks. And that's what we've seen over the past few months. Chart 1 plots a ratio of the Vanguard Total Bond ETF (BND) divided by the Vanguard Total Stock Market ETF (VTI). The big jump in the ratio since the start of October reflects a dramatic shift by investors out of stocks and into bonds. As its name implies, the VTI measures the "total" stock market which includes smaller and large cap stocks, as well as growth and value. The BND closely tracks the Bloomberg Barclays U.S. Aggregate Bond Index which includes intermediate maturity bonds of investment grade quality. Its biggest holdings, however, are in Treasuries which have been the strongest part of the bond universe (more on that shortly).

After jumping to the highest level in more than a year during the fourth quarter, the bond/stock ratio pulled back during January (as stock prices rebouded). The ratio has pulled back to its highs formed during last February and April which could provide new support. That would suggest that the January stock rebound may be nearing completion. The fact that bond yields haven't followed stocks higher this month suggests that bond investors remain skeptical of the stock rebound. The recent upturn in the bond/stock ratio is the biggest in three years before the last upleg of the nearly ten-year bull market in stocks began. Which means that it shouldn't be taken lightly. Given the age of the bull market, any signs of a major shift in asset allocation preferences needs to be taken more seriously.

Chart 1

TREASURIES LEAD OVER CORPORATE BONDS ALSO SHOWS DEFENSIVE TILT ... Chart 2 compares the performance of the major bond categories over the past quarter. Bond ETF symbols are shown on the top left of the chart. Treasuries are in the lead. That includes the 20-Year Treasury Bond iShares (black line), and the 7-10 Year Treasury iShares (blue line). The rising red line shows Investment Grade Corporate Bond iShares (LQD) lagging behind. The green line is the weakest of the four and represents High Yield Corporate Bond iShares (HYG). The fact that Treasuries are doing better than corporate bonds also shows that investors are in a defensive mood. In a strong economy, investors normally favor corporate bonds over Treasuries. In a weakening economy, they favor safer Treasuries over corporates. To go a step further, the fact the investment grade corporate bonds (red line) are outperforming high yield (or junk) bonds (green line) is another sign of caution. High yields bonds are more closely tied to the stock market, and usually lead on the upside when stocks (and the economy) are strong. The fact that high yield bonds are lagging behind Treasuries and investment grade corporates is another sign that investors are favoring safer bond categories over riskier ones more closely tied to the economy and the stock market.

Chart 3 compares major bond categories to the S&P 500 since the start of October (see symbols on upper left). The bond ETFs are plotted "relative" to the SPX which is the flat black zero line. The most important message from the chart is that all bond categories outperformed the SPX since October. There again, the juxtaposition of the various bond categories carries a couple of additional messages. The fact that the 20+Year Treasury bond iShares (blue line) are doing the best is another sign of caution. Longer range bonds are the most sensitive to the direction of the U.S. economy and inflation. So not only are investors favoring bonds over stocks; they're also favoring longer-range Treasuries over shorter maturities, as well as investment grade corporates and junk bonds. That shows that investors are favoring safer and more defensive bond categories that would benefit the most from a weaker economy and stock market. In conclusion, the fact that all bond categories have outperformed stocks since October shows investors playing defense by the most in three years. The added fact that they're also favoring the safest bond categories is an additional sign that investors are hedging their bets on stocks and the economy.

Chart 2

Chart 3