Are you experiencing even more difficulty than usual these days trying to figure out where stock prices are headed? The same for bond prices?
Or, have you discovered it may not even be worth trying to venture a guess?
Perhaps not guessing at all makes the most sense. But as a newsletter publisher dedicated to helping investors with these
sorts of questions, mostly I don't feel I have the luxury of just saying "Well, we'll just wait and see how things go."
While many may think it not possible to answer such questions, I feel I
have developed a few insights and uncovered a few data points down through the years that should enable me to have a decent sense
as to what investors can expect next in these seemingly unpredictable markets.
I have used and refined this knowledge down through the years to help guide me, and (hopefully) some of my
readers, to do far better than the average
mutual fund investor. (At least that is what a well-informed appraisal of my investing recommendations and the actual performance
of my own portfolio would appear to show.)
As a long-term investor, I have had many successes down though the last 15 years, most notably in figuring out where the opportunities lay
after the dot com crash, increasing my stock investments starting in 2009, in recognizing the value of bond investments during
these years, and perhaps most important of all, not selling out of stocks in spite of two horrendous bear markets.
All of this has given me considerable confidence that I have a fairly good sense of where stocks and bonds might be heading,
not necessarily in the next 6 months or year, but over at least the next several years.
on bottom of page 5)
What Today's Bond Prices Suggest About What Lies Ahead for Stocks
By Tom Madell
Interested in some data that may shed some light on the future direction of both stock as well as bond prices?
An analysis of the relationship between the annual rate of return between long-term treasury bonds and the return of the
S&P 500 index during 1999 and 2013
shows a huge inverse relationship over the period.
Specifically, when long-term government
bonds have done very well, the S&P has done very poorly, and vice versa. Consistent with this, somewhat
average returns for bonds corresponded to near average
returns for stocks. Such a strong degree of negative correspondence between
stocks and bonds could have only happened by chance one time in a thousand, according to statistics.
Since long-term bonds are doing extremely well this year, if this relationship continues to hold true in 2014, one would expect
that by year's end, stocks may have lost much of their gains this year thus far. Of course, the reverse might happen as well. That is,
if stocks continue to do well, it may be bonds that lose much of their gains.
Let's cite a few examples of this negative relationship. In 2013, a Vanguard bond fund investing in long-term treasuries
returned about -13% while the S&P returned over 32%. However, in 2011, while the same bond fund returned over +29%,
the stock index returned about only 2%. This high-low, low-high, (and average-average) pattern was generally characteristic
of the entire 15 year period with perhaps the only exception occurring in 2001.
Data for the entire period is shown in
the following chart which shows the yearly returns for the bond fund from best
to worst along with the corresponding return for the Vanguard 500 index fund:
(continued on page 2
(What Today's Bond Prices Suggest About What Lies Ahead for Stocks,
continued from page 1)
Long-Term Treasury Total Return
Stock Index Total Return
Note: The long-term treasury return is the return from Vanguard Long-Term Treasury Fund (VUSTX).
How can you explain these results? And more importantly, do these results perhaps suggest something about where to invest in the future?
During this 15 year period, it appears that whenever investors felt they would get good on-going returns from stocks, they would
dump their long-term bonds/bond funds/ETFs. Conversely, whenever it became clear the S&P was likely in a prolonged slump,
investors seemed to take
refuge in long-term government bonds. The pattern was so strong that whenever stocks were doing well, it could be taken as a highly
reliable sign that treasury bonds would do poorly. Likewise, deep drops in stocks could be interpreted as suggesting there would
be excellent bond returns.
Consequently, if one believed that it was going to be a bad year for long-term bonds, they could do well by increasing their allocation
to stocks. Alternately, a good year thought to be upcoming for such bonds likely meant one might want to reduce their commitment to stocks.
If you plotted the return of stocks at the end of each year
from very low (as during bear market years) to very high (as during bull markets) against the return for the bond fund,
one would see close to a straight
line relationship between low returns in one of these asset categories and high returns in the other, as shown in the accompanying graph,
confirming the above correlational data.
If there were no relationship between the two sets of graphed returns, each of the yearly return data points shown would appear
more or less in a random fashion on the graph, not in close proximity to the sloping line depicted.
Narrowing down the time frame to just the last 5 years, the strong inverse relationship between stocks and bond returns
can also readily be seen in the following graph
that overlays the ongoing price
performance of both of the above two funds.
As the graph shows, the two lines representing net asset values
almost appear to be mirror images of each other; when one goes up, the other goes down.
But if you observe the graph more closely, you will see that since Jan. of this year, unlike the rest of the graph, both lines are not
opposite directions, but are going up together. What this suggests is that the prior pattern going back to mid-2009 (and even to 1999) may be
changing. We'll return to why this may be the case shortly.
(Note that the graph only plots price performance, not total return; thus, returns, especially for treasury
bonds, would be considerably higher over the 5 year period than depicted. For example, the 5 year annualized return for VUSTX is
currently about 7.5% per year.)
The Relationship Between Bond and Stock Prices Before 1999
It might seem, then, that the relationship between long-term treasury bond prices and stock prices would always run in opposition
to each other, making it perhaps relatively easy to forecast stock returns assuming you could correctly anticipate bond returns. But
unfortunately, like many other measures that seem to offer an important insight into how to forecast stock prices, or even
allocate between stocks and bonds,
things that are true over
one extended period of time often fail to show the same relationships over other long periods.
The relationship between stock and bond prices offer
just such a disparity.
As above, let's look at a table comparing the same two funds' total returns for the period 1987 through 1998, again ordered from best
annual returns for the bond fund to the worst along with the corresponding returns for the Vanguard 500 index fund:
Long-Term Treasury Total Return
Stock Index Total Return
Note: 1987 was the first full year of existence for VUSTX.
Once again, we can see a strong correspondence between the two sets of funds' yearly performances, only this time the relationship
between the two total returns results nicely line up in a positive way rather than a negative one. Over the 12 year
period, only one or two years proved to be an exception to the rule, mainly in 1996, and perhaps in 1990. In fact, the relationship
between the two sets of returns prove to be almost nearly as strong as the 1999 to 2013 results,
with such a lined-up occurrence likely to occur merely by chance statistically in only 1 out of 100 cases.
Clearly, it would be helpful to have a more detailed explanation of
why these funds' performances line up at all, but even more so, why
in a positive way between 1987 and 1998 but in a negative way from 1999 to 2013.
Why the Change?
I'm not sure anyone knows for sure why the relationship between long-term bond and stock prices changed so
drastically over the last 15 years or so from, at a minimum, the prior 12 years. But let's look at a possible explanation.
Normally, based on historical data, one would expect there to be a positive relationship between
bond prices and stock prices. Why? Bond prices are very sensitive to the direction of interest rates and to
subsequent inflation which tends to be highly related to this upward or downward direction. When
rates are falling (or perceived to be about to soon), long-term bonds should do
well. On the other hand, if rising (or perceived to be about to soon), bond performance should start to
Stock prices are also sensitive to interest rates and by consequence inflation. Stocks, like bonds, usually thrive in a low interest rate
environment. Therefore, it would make sense that bonds' and stocks' performance should be
positively related. This may have been what was happening between 1987 and 1998. That is, in the decade of the 1980s long-term interest rates
were much higher as compared to more recently. In 1987, they rose anew but the high yields available helped to offset
the following year's returns. But as they began to fall in earnest starting in 1989 for the following 5 years, both stocks and bonds
responded positively. As rates vacillated over the rest of the period, stock and bond prices tended to move as predicted by
either rising or falling interest rates.
But starting around 1999, a pattern resembling what has been called "risk on/risk off" emerged. As stock prices
became highly volatile and lurching toward extreme outcomes, investors would either embrace risky investments when they sensed that stocks were "the
place to be," or avoid them when their fear level was stoked by turmoil in the markets. Under such conditions, although still
sensitive to interest rates and inflation which were both becoming very subdued, rather than keying
mainly off interest rates and inflation, they tended to be influenced more by potential gains (as represented
by stocks) vs. the desire for safety (as represented by bonds).
The two stock market plunges of the 2000s helped to fan fears, while market
bouncebacks, especially over the last 5 years, were accentuated further by the Fed
maintaining extremely low interest rates and easy policies which served to push investors out of treasuries and into stocks. This, of
course, would have exacerbated the high stocks, low bond pattern. During 2011, however, as long-term interest rates dropped precipitously,
investors couldn't help but seek out the huge returns being generated in longer-term treasuries. Meanwhile, investors worried that deflation,
not inflation, would hurt the economy and thus became much more cautious about stocks. Since then longer rates leveled out and
subsequently began rising again through the end of 2013.
(What Today's Bond Prices Suggest About What Lies Ahead for Stocks,
continued from page 4)
Another Change Starting in 2014?
But perhaps now over 10 years after the dot-com implosion and five years after the financial crisis, investors
have begun to sense that things are finally getting back to normal. With some sense of stability returning, encouraged
by the notion that the extremely easy credit conditions offered by the Federal Reserve will start to be withdrawn, investors
can start focusing again on the fundamentals of interest rates and inflation as important gauges of both future
stock and bond prices.
With inflation, and especially, interest rates remaining at rock bottom levels, investors are right now attracted to
both stocks and long-term bonds and no longer are the two types of investments pitted so much against each other. So
long as rates and inflation expectations remain this low, bonds and stocks may continue to thrive together.
But what happens when the inevitable does happen? The Fed will almost certainly start raising rates some time next
year. The chances are increased that a rise in inflation is also in the wings which will certainly be one of the
reasons the Fed will choose to act.
Under such conditions, bond prices are likely to react negatively. If stock investors perceive that interest rates,
and especially inflation, are likely to move up faster than anticipated, they may use this occasion as a reason
to take money out of the stock market, particularly in light of the extreme profits many have enjoyed and the
fact that many authorities concur with my view that stocks are, by most reckoning, highly overvalued.
On the other hand, stocks
might possibly continue to rise due to the assessment that rates and inflation remain well below average and
economic growth prospects remain good. And if so, long-term bond prices although not likely short-term ones, could
continue to do well until such time that interest rates and inflation expectations jump significantly higher than
they are now.
However, I feel that the most likely scenario is that with the principle of
risk on/risk off no longer in play, stocks and bonds will continue the "new" relationship that they have reverted to
starting this year. That is, the correlation
between stocks and bonds will likely remain positive. (This "new" relationship corresponds much more to the long-term history of
the relationship between
stock and bond prices prior to the data included in this article.)
This would mean that we have now re-entered the pre-1999 phase in
the relationship between stocks and bonds. Thus, when bond prices start to move down, as they very likely will
in response to rising interest rates and inflation, so will stock prices.
(Investment Data: If Only It Were More Consistent,
continued from page 1)
So when I try to apply these insights right
now, what am I able to come up with? Perhaps surprisingly, many of my usual data points have become a little less clear, but not
so much so that I am no longer willing to express an opinion.
The problem, as I see it, is that much of my analysis over the last 14 to 15 years (I started my Newsletters in 1999) is based on
what happened during that period. That data has been highly consistent. But what if for some reason, the relationships in that data that proved so
useful in understanding the markets were prone to radical change without any easily understood reason? If so, the kinds of assumptions
that one might have correctly made during that period might now possibly lead one to different conclusions.
In my main article in the right hand column back on the first page, I will show how one set of key data may be subject to such drastic change
that any former insight which applies it in an attempt to understand of future stock and bond prices may have to be completed altered.
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