There was a time when a positive correlation existed between stock prices and bond prices. But will they ever take up with one another again?
Stocks and bonds have been moving in opposite directions for so long now that an entire generation of traders, those whose first experience of a bear market was in 2000, has no idea the two asset classes were formerly fellow travellers.
The positive correlation between stock prices and bond prices existed pretty much until the mid-to-late 1990s. The reason was based on mathematics. Interest rates, usually a long-term rate, are used to determine what the future cashflows (dividends) of a company are worth today, otherwise known as their present value. When interest rates go up, a dollar today becomes relatively more valuable than a dollar received tomorrow, so the value of the future cashflows, and what an investor is willing to pay for them, goes down.
The bull market from 1982 to the mid-1990s 'can be fully explained by the changes in interest rates and earnings,' says Paul McCrae Montgomery, a market analyst who publishes Universal Economics. 'After 1994, stocks slipped their moorings and rose exponentially, unrelated to earnings or interest rates.'
After three years of a bear market, much of the out-of-whack pricing in the equity market has been corrected, says Montgomery. The yield on stock earnings is more in line with the yield on treasuries.
Specifically, at 3.9% the yield on the 10-year treasury is 1.2 times the 3.2% earnings yield (the inverse of the P/E ratio) on the Standard & Poor's 500 companies, according to Tim Hayes, chief equity strategist at Ned Davis Research in Nokomis, Florida. That is close to the historical average of 1.4 since 1981.
By this measure, among others, stocks were 'showing signs of risk from a valuation point of view when the 10-year treasury yield exceeded the earnings yield by 1.5 times during 1998,' says Hayes.
It got worse before it got better. During the second half of 1999 and early part of 2000, the bond/earnings yield ratio was over two.
Investors were not buying stocks for the yield then, and they are not buying treasuries for the yield now either. 'They are buying them because, one, bonds are not stocks, and, two, the prices are going up,' Montgomery says.
Treasuries were and are a safe haven: a place to avoid the punishing losses of the stock market; a place to hide when tales of corporate malfeasance and accounting chicanery dominated the headlines; a place to run when geopolitical uncertainties took their toll on risk assets.
The mathematics of the stock/ bond relationship and the psychology driving it are two different things. Mathematically, with earnings yields and bond yields back to a more normal relationship 'it makes sense for stocks and bonds to start moving together,' Montgomery says. 'Psychologically, there is no evidence that we have reached that point just yet. Market action is still being driven by a lower brain-stem function.'
It is hard to remember the days when bond traders focused on more than the intraday moves in the stock market.
'The flip occurred sometime in 1997 and 1998 when bond traders recognised that the stock market was the most important economic indicator,' says Jim Bianco, president of Bianco Research in Chicago. 'Higher stock prices begat better economic activity, which was bad for bonds.'
This message, that the stock market is the economy, is being reinforced each and every day in Washington, says Bianco.
'The centrepiece of the Bush economic stimulus plan is a cut in the tax on dividends,' Bianco says. 'It is supposed to get the economy moving again, but it is really about getting the stock market moving again.'
I would challenge his assertion. The elimination of the double taxation of dividends is good policy as it removes a distortion in the tax code. But to listen to some of Washington's sales and marketing, you would be forgiven for being confused.
Will stocks and bonds ever take up with one another again? They went down hand-in-hand in the 1970s and up as one in the 1980s.
This should be the sweet spot of the business cycle, when the economy can grow fast without generating inflationary pressure (lots of unutilised resources) and earnings improve. Technically, there is nothing to prevent stocks and bonds from rallying.
Except for the minor point that both asset classes are expensive. According to Ned Davis Research's proprietary models, stocks are expensive on an absolute basis, with a P/E ratio of 28 for the S&P 500 Index compared with an historical norm of 15.6 since 1926. Bonds are expensive based on 'external indicators, such as nominal GDP, the CPI, and the budget deficit,' says NDR's Hayes.
There is one option left if stocks and bonds are to reassert their positive relationship.
'We believe that before this long-term bear market is done, there will be a period when both stocks and bonds go down together,' Montgomery says. 'Conventional asset allocators will have no place to hide.'
Bloomberg newsroom, New York
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