Study: how is the bond market a leading indicator for the stock market


The bond market can be a leading indicator for the stock market. This is because the stock market has massive amounts of “dumb money” while the bond market has more “smart money”.
The stock market lags its real-time fundamentals (i.e. economic data). This means that equities bull markets top AFTER the fundamentals have deteriorated significantly. The majority of retail mom-and-pop investors ignore the deteriorating fundamentals until the problems are so obvious that they can no longer be ignored. That’s why the “buy the dip” mentality can push the stock market to new highs when the fundamentals first begin to deteriorate.
“Dumb money” retail investors have a big influence on the stock market. But the bond market is different – the majority of bond market players are large institutional funds. This means that the “smart money” has a bigger impact on the bond market than the stock market.
So here we have a unique scenario. Here’s how bull market tops work:

  1. The fundamentals (economy) start to deteriorate.
  2. Bond market investors and traders react first because they are more aware of the fundamentals. They start to sell bonds, which is why the bond market falls first and yields start to rise. Meanwhile the stock market continues to go up in a choppy manner because the majority of stock market investors “buy the dip”.
  3. The fundamentals and economy continue to deteriorate.
  4. The fundamentals deteriorate so much that stock market investors can no longer ignore this problem. The “buy the dip” mentality dies down, and the bull market in equities tops.

How to use the bond market to predict the stock market

The leading-lagging relationship between bonds and stocks implies that yield spreads must rise significantly before a bull market in stocks can end.
If yield spreads are making new lows in this equities bull market, then you know that the bull market is definitely not over. You can continue to maintain your long term bullish case. Yield spreads MUST rise for at least a few months before a bull market in stocks can top.
However, rising yield spreads is not enough to cause a top in the stock market. Rising yield spreads is NECESSARY but NOT SUFFICIENT for a bull market to top.
*Yield spreads look at the difference between corporate bonds (riskier bonds) and Treasury bonds (deemed “risk-free” bonds). A rising/widening spread implies that bond investors are becoming more risk-averse. A shrinking/falling spread implies that bond investors are becoming less cautious.
There are various classes of bond spreads: high yield bond spreads and low yield bond spreads. In layman’s terms…

  1. High yield bond spreads = “junk bond yields” (high risk) – Treasury yield
  2. Low yield bond spreads = “investment grade bond yields” (low risk) – Treasury yield.

Low grade bond spreads are usually the first to react to deteriorating fundamentals.

The High Yield Spread is one of the best leading indicators for the stock market

Bank of America Merill Lynch’s US High Yield CCC or Below Spread is one of the best bond market leading indicators for the stock market.
Historically, the high yield spread always trended higher for AT LEAST a few months before a bear market in stocks began.

  1. High yield spreads trended higher from September 1997 – December 2000. The U.S. stock market peaked in March 2000. The bond market led the stock market by almost 2.5 years.
  2. High yield spreads trended higher starting from May 2007. The stock market peaked in October 2007, 5 months after the bond market peaked. The bond market led the stock market by 5 months.

Here’s the chart.

Rising high yield spreads are mostly coincident with “significant corrections” in an equities bull market (i.e. yield spreads rise at the same time as the stock market falls). But rising high yield spreads can sometimes (but not always) be used for predicting “significant corrections” in a bull market. Yield spreads sometimes lead significant corrections in the stock market.
Here are examples of the coincident cases.

  1. The high yield spread went up from April – August 2010. The S&P 500 made a “significant correction” at the same time.
  2. The high yield spread went up from April – September 2011. The S&P 500 made a “significant correction” at the same time.


But sometimes the bond market is a leading indicator for “significant corrections” in equities bull markets. As you can see in the following chart, the yield spread went up from July 2014 – February 2016. The stock market made a “significant correction” from May 2015 to February 2016. The bond market led the stock market by 10 months.

The BBB bond spread as a leading indicator for the stock market

In layman’s terms, the BBB bond market is comprised of “medium credit quality” bonds. The credit quality on these bonds is higher than the credit quality on CCC high yield bonds.
Like the high yield spread, the BBB spread can also be used as a leading indicator for bear markets in stocks.

  1. The BBB spread went up from February 2007 – 2008. The stock market peaked 8 months after February 2007 in October 2008. The bond market led the stock market by 8 months.
  2. The BBB spread went up from September 1997 – 2000. The bond market led the stock market by 2.5 years.

And like the CCC spread, the BBB spread can sometimes (but not always) be used to predict “significant corrections” in the stock market. For example, the BBB spread went up from July 2014 – February 2016. This led the stock market’s “significant correction” by 10 months.

Where is the bond market today

There has been no divergence between the stock market and the bond market so far.
BBB spreads bottomed in January 2018, just when the U.S. stock market topped. This suggests that in order for the equities bull market to top, the stock market must make a new all-time high while the BBB spreads must start to trend higher.

Another medium-long term bullish sign for the stock market is that the CCC spreads have CONTINUED TO FALL even though the stock market has made a correction! When the stock market’s correction is over and the market rallies, the CCC spreads will probably continue to fall a little more.

These 2 bond markets suggest that the recent stock market decline is just a correction. The bull market in equities will continue.
Remember, CCC spreads have to rise while the stock market is rising before a bear market in stocks can begin.

When the bond market can’t be used to predict the stock market

You can only use yield spreads to predict the stock market. You cannot use the absolute value of bond yields to predict the stock market. For example, here’s the AAA corporate bond yield index. There is no clear and consistent leading pattern between bond yields and the stock market.

  1. Sometimes corporate bond yields rise before a bear market in stocks begins.
  2. Sometimes corporate bond yields fall before a bear market in stocks begins.
  3. Sometimes corporate bond yields are flat before a bear market in stocks begins.

4 comments add yours

  1. You had asked for questions. Mine was interest rates and you have posted. I will print and study. Thank You…

  2. This is an excellent article, thank you. I like the distinction you made between using the bond yield spread vs. the absolute value of bond yields. This make perfect sense. I’m interested to know more about the overall psychology and strategy in the bonds vs. stocks markets.

    • Hi Steven,
      The bond market is much harder to trade than the stock market. This is because the bond market has many different kinds of market players: central banks, large institutional funds, mom-and-pop investors.
      At least in the U.S. stock market the central bank is not a factor. The U.S. government does not directly buy and sell stocks. But it does directly buy and sell bonds via the Federal Reserve.
      Regards,
      Troy

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