After last month’s fight on Capitol Hill, and the 11th-hour deal to raise the debt ceiling, many investors are asking whether it’s still safe to be in the U.S. stock market.
One of the best ways to answer this question is by looking at the relationship between stocks and bonds.
When stocks are rising relative to bond prices, as they have been all year, the economic outlook is said to be “net bullish.” Conversely, when demand is greater for bonds than for stocks, it’s called “net bearish.” As you would expect, growth-oriented assets such as stocks go up under net bullish conditions. And conservative investments such as Treasury bonds outperform under net bearish conditions.
|On a relative basis, stocks are still more attractive to investors than bonds.|
To learn more about how the relationship between stocks and bonds can predict a market crash, click here for more insight from Doug.
After the most recent debt debate, you might argue that U.S. government bonds are not as safe as they used to be. But the vast majority of market participants still believe that the risk of default is essentially nil.
In May 2011, the demand for bonds, as measured by the iShares Barclays Aggregate Bond Fund (AGG), began to outperform the S&P 500, the best measure of the demand for stocks. In other words, economic fear was greater than economic confidence. But perhaps the most important thing to notice in the chart below is that the trend shift acted as a warning signal, presaging the end of the rally in the stock market, which peaked in July.
That trend shift and subsequent downturn in the stock market happened more than two years ago. Since then, equities have rebounded with a vengeance, with major U.S. indices reaching new all-time highs. But is this party coming to an end? Based on its previous prescience, we can consult the same chart for an answer.
Some defensive cracks have appeared in the stock market over the past two weeks, but as you can see, bonds clearly remain in a downtrend relative to the S&P 500. The doomsayers who warn of an approaching crash may eventually be proven right, but judging from this ratio, the violent trend shift they’re predicting is not imminent.
Bond-to-Stock Demand Ratio
Investors who have already switched to a risk-off stance advance the argument that the Federal Reserve has manipulated the bond market for years. They’re worried that once the Fed begins tapering its quantitative-easing program, interest rates will spike.
That may be true, but if tapering and rising rates harm the economy, we can still expect stocks to underperform bonds. Remember, the chart we’ve been studying is relative; the ratio between AGG and SPY can still rise if bonds are falling, but stocks are falling more.
That is not what we’ve been seeing recently. On a relative basis, stocks are still more attractive to investors than bonds. Until the market’s pricing mechanism shows that the aggregate opinion has shifted in favor of deflationary and risk-off assets, such as bonds, inverse stocks, CDs, etc., investors can feel comfortable sticking with a risk-on strategy.