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Stocks, Bonds and Behavior Bucks


Random positive reinforcement...maybe you should try that with Boo!


My oldest son has a tendency to lose focus and not do what he's supposed to do.

We've tried about everything, but a few weeks ago we came up with "Behavior Bucks" – little coupons that my wife and I made and could dole out whenever we caught him doing something he was supposed to do without being asked more than once. I've read that random positive reinforcement gets the best results for dogs, so I thought what the heck, let's try it with the boy.

Well, it's working, and I get a kick out of watching the gears turn in his head as he's trying to decide what to do with his Bucks – spend a few now and stay up an extra ½ hour, or save 'em up for later and go to a Minnesota Wild game.

I'm hoping that besides adjusting his behavior, this little exercise is going to help teach him to make wiser decisions – looking forward a few weeks instead of just a few minutes.

As investors, we face a similar struggle. We have to constantly judge where the best place is to store our funds based on what we want now versus what we might need later. There are an innumerable number of choices, of course, but the vast majority of the population concentrates on only two asset classes: stocks and bonds.

When the expected yield on the two are competitive (we're beginning to approach that area now), the battle for investment dollars becomes more heated and those little gears in our heads start working overtime.

I'm not going to go into the merits of investing in one or the other, or the expected payouts versus inherent risk. Instead, I want to show a relatively simple ratio between the two that reflects current investor preferences.

In the chart below, the Stock/Bond Ratio is expressed as the number of standard deviations the current reading is from its historical norm. The more extreme the reading, the more likely it will snap back in the other direction.

Making a few assumptions, theoretically we should expect a reading above plus 3 or below minus 3 about 3 times out of every 1,000 observations. Interestingly, when looking at the actual results of the Stock/Bond Ratio, it has exceeded those thresholds 4 times in the past 1,000 days – about what we should expect.

Well, make that 5 times.

On Friday, the ratio poked above that +3 line. Historically this has been a negative omen for stocks going forward. In 1998 and 2000, it coincided with the exact peak in the S&P 500, while in 2004 and 2005 we saw a bit more of a run before the gains were given back.

Since 1994, the ratio exceeded +3 on six different occasions. Over the next three months, the average maximum gain after those occurrences was +1.7%...but the average maximum drawdown was -8.7%. On five of the six, the maximum drawdown was three times greater than the maximum gain.

The coming quarter is supposed to be far and away the best one of the year for stocks. From what I read, near everyone already knows that (just like we all knew about September being the worst one…). But based on the current tilt in the Stock/Bond Ratio and some other measures I follow, I'm starting to question just how sustainable further upside is going to be.

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No positions in stocks mentioned.

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