Friday, January 13, 2006

Bonds and Stocks - Interesting Relationship

A reader suggested to me that I take a multidimensional approach to historical patterns and investigate intermarket relationships such as between bonds and stocks. This is an excellent suggestion, and it highlights the need to look at many patterns before jumping in and trading any single one. An approach I like to take is to look at non-overlapping patterns (such as between daily SP and bonds, daily SP and advance-decline, and weekly SP and volume) and see if there is a consensus among the "committee of experts". Some excellent trade ideas emerge when you see a pattern edge from multiple patterns.

The bond/stock relationship is a complicated one. As we can see from the chart above, which covers 2003 - present, the price of the DJ corporate bonds is highly correlated with the price of the S&P 500 Index. When we look on a day to day basis, however, the correlation is -.12! A strong or weak day in bonds tells us very little about whether that day was strong or weak in stocks. Over a period of 40 days, however, the correlation is .38--positive and significant.

Note that dips in bond price have been excellent points to purchase stocks. But note also that the current price highs are the first ones since 2003 to go unconfirmed by the bonds. To the extent that bonds lead stocks, there might be a message there. I will investigate this further and post tomorrow.