Sunday, January 15, 2006

Weak Stocks and Bonds - Continuing the Investigation

Yesterday's entry looked at strong days in the stocks since 2003 and found a tendency for near-term reversal, especially when bonds were also strong. That made me curious about weak days in stocks (SPX). Is the outlook following weakness different as a function of bond prices?

Since January, 2003 (N = 760), we've had 185 days in which SPX has been down by half a percent or more. The next day, stocks have risen on average .12% (112 up, 73 down), which is considerably stronger than the average rise of .03% for the remainder of the sample (310 up, 265 down). This is the pattern of strength following weakness that we've encountered before.

Once again I subjected the weak SPX days to a median split based upon bond price performance that day. When bonds were weak and stocks were weak (N = 93), the next day in stocks averaged a gain of .26% (62 up, 31 down). When bonds were strong and stocks were weak (N = 92), the next day in stocks averaged a loss of -.02% (50 up, 42 down). Again, this is counterintuitive. You would think that falling stocks and rising interest rates (falling bond prices) would yield weak stocks going forward. Just the opposite is the case: when stocks have been strong and bonds strong, we've had subnormal short-term returns going forward. When stocks have been weak and bonds weak, we've had above average short-term returns.

These patterns will be worth following, especially given the recent divergence between stocks (which have made new highs) and bonds (which have not).