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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Signs of Wave 2- Consumer Confidence Slides

It appears as though the US equity markets have been correcting since June 11, 2009 after recording a 30% rally over 3 months. If someone had bought DIA with $200,000 at the bottom, he or she would have made $60,000 in 3 months. Let's say a person only caught 20% of the rally. Then the person made $40,000. That's one good news. And the other one is that you can still make money as the DJIA retraces in the second wave.

I outlined the wave personality of each wave in the wave cycle on technicalanalysisbase.blogspot.com. CLICK HERE to go directly to the post.

Second waves- Second waves often retrace so much of wave one that most of the profits gained up to that time are eroded away by the time it ends. This is especially true of call option purchases, as premiums sink dramatically in the environment of fear during second waves. At this point, investors are thoroughly convinced that the bear market is back to stay. Second waves often produce downside non-confirmations and Down Theory “buy spots,” when low volume and volatility indicate a drying up of selling pressure.

Just look at the recent economic news and you'll know wave 2 is here.

Today, consumer confidence unexpectedly declined and delinquencies on the least-risky mortgages more than doubled. I'm staring at 'unexpectedly' right now. First we see a huge 30% rally propelled by better than expected earnings. 'Better than expected' ... or better yet, "Unexpectedly better than expected": analyst were so pessimistic about corporate profits/performance that their expectations were a lot lower than normal. Earnings kept beating expectations and the market continued to rally. Seeing that, consumers felt more confident. Even economic reports started releasing positive news indicating improving fundamentals. Everything happened as if we didn't go through the worst recession since the Great Depression.

All this is characteristic of the first wave when people believe that the worst is behind us. In reality, the worst is actually behind us but all is not over. Wave 2 is when fear creeps in again. Its a good shorting opportunity and also a time to prepare for wave 3. Write calls or covered calls. Writing calls in wave 2 season is far less risky. Even a person with a low risk tolerance can risk writing naked calls. But only after careful consideration. For more on this topic, refer to Writing Naked Calls using Warren Buffett's Philosophy.

Wave 3- one of the wonders of the long investor's world only if it is extended, which it usually is. I'm glad we're in wave 2. It'll give me some time to gear up for wave 3 and lock in some huge returns. BUY LEAPS!

Don't forget to visit my website at http://www.technicalanalysisbase.com/ and my other blog at http://technicalanalysisbase.blogspot.com/

Sanjeet Parab_____________________________