What Happens When Bonds Start to Outperform Stocks?

It is possible for prices of individual asset classes to move in a linear up or down trend for an extended period. However, this rarely happens with inter-asset relationships, which rotate around the business cycle. As a result, it is helpful to monitor inter-asset relationships and their momentum to see what changes may be on the horizon and which assets are likely to under and outperform. Once set in motion, these transformations can provide helpful clues as to the current phase of the cycle and whether stocks, bonds or commodities should be emphasized.

In this piece, we are going to take a deep dive into one of these relationships, namely the Stock/Bond ratio, principally because it may be in the process of reversing trend.

Every so often, it's possible to observe a setup confirming that stocks have begun a new trend of superior performance to bonds. In this instance, the ratio compares the S&P Composite to the price of the 30-year bond ($SPX/$USB). The setup consists of a sub-zero long-term KST buy signal, in conjunction with a trendline break in the ratio itself. This combination is also reinforced by a positive 12-month MA crossover. It tells us nothing about the course of the absolute prices of stocks and bonds, though it is invariably positive for stocks  in their own right.

Since 1982 we can observe seven setups, all of which were followed by some kind of an advance in inflation-adjusted stocks. These examples have been flagged by the arrows in Chart 1. The first two examples, at the beginning of 1983 and 1987, did not amount to much, but the remaining setups were followed by a lengthy advance.

That said, the long-term KST has is very overstretched and has begun to roll over. This suggests that the cycle may be in the early stages of reverting in favor of bonds. KST sell signals since 1997 have been displayed in Chart 2. It is evident that sell indications were not as strong in their negative consequences as were the positive outcomes for the buy signals. That was partially due to the fact that bond prices were in a secular bull market during the period covered by the chart. About half the signals were followed by trading ranges in both the ratio and inflation-adjusted stocks. Since 2009, the ratio has been in a secular uptrend, indicating that stocks handsomely outperformed bonds.

The extended nature of the KST and its rolling-over action suggest that a reversal may be at hand, though this would have to be confirmed by the ratio dropping below its 12-month MA. Another area to monitor is the secular up trendline for the inflation-adjusted S&P, as the latest price is resting right on it. If it should be violated in any way, that would be quite a serious technical development.

Chart 3 again features the ratio, but this time with its Special K (SPK), which you can read about here. The SPK usually peaks and troughs simultaneously with the primary trend turning points of the security from which it is calculated. We cannot know for sure when it is reversing in real time. Consequently, signal line crossovers and trendline violations are used to help confirm these reversals after the fact. For instance, that was the case in November 2018, when both were violated simultaneously. Fast forward to the current situation and you can see that the SPK is already below the signal line and trendline, but not by much. I would prefer to see a more decisive drop below the line before pronouncing the SPK as fully bearish, especially as the daily KST in the bottom window has just started to turn up, implying a rally favoring stocks is on the way.

As for the ratio itself, it looks as if it could be in the process of tracing out a broadening wedge. These progressively volatile patterns indicate a gradual increase in instability. When completed, they are usually followed by an above-average price move on the downside.

Please remember, you can always update these charts by clicking on them when new data is available.

Conclusion

The ratio between stocks and bonds is very overextended in favor of stocks, but long-term smoothed momentum has started to turn down. This kind of action has consistently warned of extensive downside or range bound price action in both the ratio itself and inflation-adjusted equities. All that's required in the form of confirmation is a negative 12-month MA crossover or the completion of a broadening wedge in the ratio itself.

Good luck and good charting,

Martin J. Pring

The views expressed in this article are those of the author and do not necessarily reflect the position or opinion of Pring Turner Capital Groupof Walnut Creek or its affiliates.