Monday, January 16, 2006

Bonds and Stocks: The Longer View

As we found earlier, bond and stock prices have been positively correlated over longer time frames in the market (40 days) since 2003, but not on a day-to-day basis. We saw with day-to-day results, strong bonds and strong stocks led to subnormal returns; weak bonds and weak stocks led to above average returns.

Now we'll look at stocks and bonds over a 40-day basis. Specifically, we want to see if strong bonds over a 40 day period are associated with strong stocks over the next 40 days. Since March, 2003 (N = 686), 40-day periods have had a distinctly positive bias. The S&P 500 Index has averaged a gain of 2.33% (483 periods up, 203 down) during that time. When we conduct a median split of the data based on 40-day bond strength, we find that strong bonds yield an average gain of 3.30% in SPX over the next 40 days (260 up, 83 down). When bonds are weak, the next 40 days in SPX average 1.35% (223 up, 120 down).

What we're seeing is a very different pattern in the short-term and longer-term data. For intermediate-term traders and for investors, bond strength is bullish for stocks. For short-term traders, bond strength has been bearish for stocks. Knowing one's time frame and price patterns typical of one's price frame is all-important.