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Courting Stocks and Bonds


Despite conventional wisdom, inverse relationship exists.


In technical analysis, relationships matter. The relationship between stocks and bonds is one that has always interested investors and traders.

For most of the postwar period (WWII) until 1998, stocks and bonds had a tendency to trend together. Furthermore, during that period bonds had a tendency to lead stocks; bonds would turn ahead of stocks, and they were a reliable indicator that stocks would eventually follow. There were exceptions of course, but they were usually, panic induced "flight to quality" periods that were of relatively short duration; months, not years.

The concept of stocks and bonds trending together remains in most financial textbooks and remains a truism in the mind of most investors. In reality, however, an inverse relationship, where stocks and bonds move in opposite directions, is the primary tendency and the basis of the relationship between the two since 1998. In the monthly chart below I have placed a vertical red line where the decoupling began. The horizontal red lines show inversion, blue lines show them moving together.

Click to enlarge

In past articles I've discussed how patterns and cycles in the markets can last for decades and then suddenly stop working. The Kitchin cycle lasted 78 years before it stopped working. It later resurfaced but it was inverted and less reliable. The most common belief of a pattern's failure is public awareness.

For the change in the relationship between stocks and bonds, however, there is a fundamental theory. John Murphy explored the reason for the decoupling of US stocks and bonds in his book, Intermarket Analyisis. He identified that this inversion between stocks and bonds happened once before, during the deflationary period of the 1930s, and later reverted back to the textbook pattern. He concluded that the phenomenon occurs during deflationary periods, or, when the perceived market risk of deflation is higher than the risk of inflation.

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Let me over-simplify deflation. If the pumping up of a tire is credit expansion, letting the air out of the tire is deflation. If you over inflate the tire, you run the risk of a blow out.

The deflationary shock that decoupled stocks and bonds in the first place was believed to be the Asian currency crisis that started in 1997 and spread to Russia and Latin America and threatened global markets. The poster child was Long Term Capital Management.

A decade later the decoupling still exists. A decade characterized by one credit crisis resolved by the spawning of another. Imagine a tire with multiple compartments that hold air instead of one contiguous compartment. Since 1998 the economy has managed to counter a blowout of each compartment by over inflating another compartment, thereby managing to keep the tire inflated. Yet, this increases the risk of total deflation because of the increased number of patches. Can this compartmentalized patch work occur indefinitely, or, are we headed for a blowout?

Does the relationship between stocks and bonds hint at the answer, or, is it just another case of public awareness disrupting a profitable pattern?

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No positions in stocks mentioned.

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