May 15, 2008

Bond market yields and stock market

Smart money is always vying for quicker ways to make money. That is why they pay so much to researchers and analysts, to identify the next best possible sector to invest in. When a particular sector is due for a breakout, the smart money moves in, rides out the wave and make windfall profits. Smart money can move among stock markets, bond markets, gold market, real estate, international markets and many others. In this segment, lets see one way of how money can move between Stock markets and Bond markets. Many analysts use variations of this analysis as an indicator to track the smart money trail.

Chart1 below shows the variation of S&P 500 with the ratio of SP500 yield/10 year yield. As the ratio goes above 1, the SP500 yield becomes attractive than 10 year yield, and money will start moving into stock market. The idea is that the money moving into stocks is attracted by the earnings yield of SP 500.
You might also notice that during 1998-1999, the ratio was declining but the market kept moving up. That could not have sustained for long since the divergence on the chart would have made the bond markets lot more attractive. The divergence is indicated by the arrows.

Another way to look at the same data is to reverse the ratio. Chart2 below plots S&P 500 against the ratio, 10yr-yield/SP500-yield. Usually the portfolio managers will not switch as soon as the ratio moves across 1, but they rather wait to make sure that the crossover is a sustained one and not a volatile spike. Hence I made a small tweak to Chart 2 - the ratio is now the difference of 10 year yield over 1.15 times the SP500 yield. The signal is bearish for stock market when the pink line crosses above 0.Chart 3 below is similar data, but using yield differential rather than the ratio. That is, it is a plot of SP 500 against the difference between 10 year yield and SP 500 yield. Generally when the yield differential is greater than 2 percent points, then that signifies bearish signal for the stock market.
These charts are depicting the yield spreads and ratios only till the fourth quarter of 2007. You can see that Chart 3 is not bearish for stocks yet, but Chart1 and Chart2 are somewhere in the border of Tip-over point.

Let me know if there is any other web page where we can get data sooner. I know that as of this week, 92% of the S&P 500 companies have reported earnings. SP500 yield data for 1Q 2008 is not available on S&P website yet, otherwise I would have uploaded the charts with 1Q data.

-Nidhi

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