Saturday, January 14, 2006

Strong Stocks: Do Bonds Make a Difference?

Today's entry on the Trading Psychology Weblog mentioned an interesting relationship between bonds and stocks from 2003 to the present. Of the twenty days that were strongest in stocks (SPX), sixteen of those exhibited declining bond prices. Of the twenty weakest days in stocks, thirteen showed rising bond prices. It appears to be a kind of flight from/to quality phenomenon: When stocks drop, money goes into fixed income and vice versa.

This led me to wonder if we might see different expectations when strong and weak days in stocks are accompanied by strength or weakness among bonds. Since 2003 (N = 760), we had 195 days in which SPX was up by .50% or more. The next two days, the market averaged a loss of -.10% (96 up; 99 down), much worse than the .17% average gain (311 up, 254 down) in the rest of the sample. This is the weakness following strength pattern that we've noticed before.

Now, however, let's conduct a median split and compare strong SPX/strong bond days to strong SPX/weak bond days. After the strong SPX/strong bond days (N = 98), the market averaged a two-day loss of -.23% (46 up, 52 down). After the strong SPX/weak bond days (N = 97), the market averaged a two-day gain of .02% (50 up, 47 down). Interestingly, days in which both stocks and bonds are strong have been followed by noteworthy two-day weakness.

To the extent that fixed income might serve as an alternative to stocks, a rally in both stocks and bonds would represent general optimism regarding financial assets and a putting of money to work in those sectors. When stocks are strong but bonds weak, we might be seeing a mere transfer of assets within the universe of financial instruments. When traders are overly optimistic about the financials, stocks have tended to correct over the short term. Ironically, a market rally on lower interest rates--a seemingly positive development--has led to subnormal returns near term. Tomorrow I'll look at SPX weakness vis a vis bonds.

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