Want to predict stocks? Look to bonds!
In response to a reader’s encouragement, I began taking a close look at the
relationship between the performance of stocks (S&P 500 Index) and corporate
bonds (Dow Jones 20 Bond Index). My dual hypothesis was simple:
1) Strong days in stocks should be followed by greater strength in the
near term when bonds are also strong (interest rates are falling for corporate
America);
2) Weak days in stocks should be followed by greater weakness in the
near term when bonds are also weak (interest rates are rising for corporate
America).
Given the relationship between stocks and bonds since 2003 (see below), my
hypotheses seemed plausible. But, boy, was I wrong.
Over a 40 day period, bond and stock prices correlated
positively and significantly: .38. Interestingly, however, the day
to day correlation between bond and stock prices has been mildly negative:
-.12. In fact, when we go back to January, 2003 (N = 760 trading days), we
find that, for the twenty strongest days in the S&P 500, bonds were down on
16 of those occasions. For the twenty weakest days in SPX, bonds were up
on 13 occasions. Oddly, the relationship between stocks and bonds on a day
to day basis is quite different from the longer-term relationship depicted on
the chart above.
As I recently reported on my
free research website, when SPX rises by half a percent or more in a day (N
= 195), expectations for the next two days since 2003 have been subnormal.
Selling has tended to follow buying. When stocks have been strong and
bonds have also been strong, the market has averaged a two-day loss of -.23% (46
days up, 52 down). When stocks have been strong and bonds have been weak,
the market has averaged a gain of .02% over the next two days (50 up, 47
down). Contrary to my hypothesis, strong stocks and strong bonds have led
to short-term market underperformance, not continuation of equity strength.
I then examined markets in which stocks have fallen by half a
percent or more in a single day (N = 185). Expectations for the next day
since 2003 have tended to be favorable, as selling has led to near-term
strength. When stocks have been weak and bonds have been weak, the market
has averaged a next day gain of .26% (62 up, 31 down). When stocks
have been weak and bonds have been strong, the market has averaged a loss of
-.02% (50 up, 42 down). Again, contrary to my hypothesis, weak stocks and
weak bonds have led to short-term market outperformance, not continuation of
equity weakness.
What are the lessons from this exercise?
First, test your assumptions! Nothing would be more
commonsensical than to assume that a strong day in stocks accompanied by falling
interest rates should carry over to the next day and vice versa. The exact
opposite, however, has been the case. As Joseph Granville would say, if
it’s obvious, it’s obviously wrong.
Second, when traders are buying financial assets (stocks and
bonds), they are displaying unusually positive sentiment. That may be
setting the market up for weakness in the short run. Similarly, when
traders are selling stocks and bonds, they might be displaying unusually
negative sentiment toward financial assets. That sets the market up for
short-term strength.
I will be monitoring these patterns here and on my site; stay
tuned!
Brett N. Steenbarger, Ph.D. is Associate Clinical
Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical
University in Syracuse, NY and author of The
Psychology of Trading (Wiley, 2003). As Director of Trader Development
for Kingstree Trading, LLC in Chicago, he has mentored numerous professional
traders and coordinated a training program for traders. An active trader of the
stock indexes, Brett utilizes statistically-based pattern recognition for
intraday trading. Brett does not offer commercial services to traders, but
maintains an archive of articles and a trading blog at www.brettsteenbarger.com
and a blog of market analytics at www.traderfeed.blogspot.com.
He is currently writing a book on the topics of trader development and the
enhancement of trader performance.