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A Look at the Stock / Bond Ratio


Hey, at least it's gone down a little, right?


Every day, we have to make a decision about where our money will be treated the best.

For those with a long-term time frame, the answer is usually some segment of the stock market, but those responsible for OPM (other people's money) usually have to take into account not just stocks, but also bonds, foreign exchange, commodities, real estate and dozens of other esoteric assets.

But the most basic allocation – stocks or bonds – is the one that gets the most attention and is surely the one most hotly debated. So today we're going to take a look at the Stock / Bond Ratio.

What is it?

The Stock / Bond Ratio is just that – a ratio of stocks to bonds. Both terms are pretty broad, so for this indicator what I use is a comparison of the S&P 500 exchange-traded fund, SPY, to the most available one for the bond market, the iShares Lehman 20+ Year Treas Bond, TLT.

The indicator is not a straight ratio between the two. Rather, it looks at the ratio's history over the past 90 days and determines how many standard deviations the current reading is from the average of the range.

Why should we follow it?

When one of these paper assets gets stretched too far in relation to the other – and I'm talking a true extreme here – then we tend to see mean reversion work its magic for a bit as big asset allocators like pension funds adjust their mix.
This tendency is quite consistent, and has a good record going back 40 years. We have a pretty decent sample size with that long of a history, which helps give confidence to the idea that extremes we see now will probably work the way we expect them to.

What are the challenges in using it?

The relationship between stocks and bonds is not static, as we've seen over the past 10 years. But on a shorter-term time frame, it does tend to be relatively consistent, especially when the two get really out of whack with each other.
The interpretation of the ratio is not necessarily straightforward. When the ratio suggests that stocks are overvalued relative to bonds, then it would make sense to sell stocks and buy bonds. But historically, it has not worked out as cleanly that way as just using it as a stock market barometer. It is best to use something like this to trade only one of the asset classes, not both, as you could end up losing on both sides of the trade.
What does it look like?
What's it suggesting now?

On March 15, this indicator recorded a reading over 3.0. This means that the relationship between the two at that time was 3 standard deviations outside of the norm – an extremely rare event (the red and green arrows on the chart highlight 2 standard deviation events).
The other recent times this had occurred were immediately prior to the mini-crash in 1998 and at the very top of the bubble in March 2000. It happened again in November 2004 and didn't have an immediate impact, but the S&P did stall for about the next six months.
The latest instance also didn't result in an immediate and horrific decline, but the upside in stocks was clearly limited and the recent volatility is pretty much par for the course when looking at some of the historical signals. And if we continue to follow that history, then what we've seen is just the beginning of several months of limited rally attempts.
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No positions in stocks mentioned.

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