Bonds Lead Stocks: Watch the Bond Market for Clues on where the Equity Market is Heading

It is fairly obvious that the stock market serves as a leading economic indicator. In the 8 business cycles from 1948 to 1990, the S&P 500 led turns in the business cycle by an average of 7 months, with a nine-month lead at peaks and a five-month lead at troughs. A lead time of 7 months to get ready for a major change in the economy! How about a lead time of 27 months?

For such a lead time, you need to go to the bond markets. In Geoffrey Moore’s Leading Indicators for the 1990s, Victor Zarnowitz writes:

The [Dow Jones Index of Corporate Bonds] led at each of the eight business cycle peaks since 1948 and at each of the eight troughs. Its leads at business cycle peaks were very long and highly variable, ranging form 10 to 58 months, and averaging 27 months. Its leads at troughs were also long relative to the observed distributions of such leads and the durations of business cycle contractions: they ranged from 3 to 13 months and averaged 7 months.

Although the variability of lead times is concerning, by knowing that bond markets give a longer lead time than stock markets, an analyst is better prepared for anticipate changes in the stock market and the economy. Let me make it absolutely simple.

Business Cycle Peak (Trough)

Bonds will tell you 27 (7) months in advance that the economy will peak (bottom)
Stocks will tell you 9 (5) months in advance that the economy will peak (bottom)

So, once the bonds peak, you can expect the stock market to peak as well. You will be aware of overbought conditions, saturations, bubbles, and will be in a better shape to think like contrarians.

October 2007 Peak

As the chart shows, bonds (10-year US Treasuries) peaked in May-June 2006. That gave investors a lead time of 16-17 months before the October 2007 peak in the stock market. Bond yields approached the May-June 2006 peak in June-July 2008. Even this peak gave investors 3-4 months lead time to understand the overbought nature of the stock market. You might not have gotten out at the peak, but after identifying an MA or Head & Shoulders Top, you could have limited your losses.

CAUTION: It is always easy to pick peaks in perfect hindsight. But, with some experience and a lot of practice, you will foresee things that are possibly unbelievable true. It all sounds good in writing, but you need the patience to sit through a number of months before major turns.


Conclusion

I don’t think anybody would claim perfect market timing. Neither do I. But, by understanding the correlation between bond and equity markets, you are better equipped to evaluate the merits of price action and anticipate major trend changes.

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Sanjeet Parab

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