As Sam Sees It: What the Bond Market Is Telling Investors About Stocks

Sam Stovall |

Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.

For more from S&P Capital IQ, be sure to visit www.getmarketscope.com.

EQ: We discussed last week that during the sell in May period for mid-term election years, the Barclays Aggregate actually did quite well. In this week’s Sector Watch, you also noticed that bonds are doing well in the face of the Fed’s tapering, which is a bit of a surprise. Why is that happening?

Stovall: First off, bonds have done very well. Since 1977, the Barclays Aggregate has risen an average of 7.6 percent from April 30 through October 31 as compared with a 3.3-percent total return for the S&P 500.

If you look to just mid-term election years, the S&P 500’s advance declines to 1.3 percent but the Barclays Aggregate gets even better, showing an average gain of 12.5 percent. Of course, this is all during that very long-term secular bull market for bonds.

However, I think what it shows is during the more sensitive seasonal period, investors look for a little more defensiveness and have traditionally moved into bonds during this challenging six-month period.

As far as the reason why I think bonds have been doing so well this year is because investors are concerned about global economic growth. In the U.S., expectations were for a 3-percent gain for the full year, but because of weaker-than-expected data and the much-weaker-than-expected first quarter GDP report, the consensus is now closer to 2.5 percent.

So I think investors in general feel that stocks went up too much last year, and the economy itself is not proving that investors made the correct move. So as a result, bond investors are wondering if they got out of their fixed income holdings in too great a quantity and are now looking to get back in.

EQ: You also looked at the rolling 12-month return for stocks versus bonds and noticed that the gap had widened much further than the historical average. If we see a reversion to the mean, will this be more of a snapback move or can it be more of a gradual slide?

Stovall: That gap is also known as the equity risk premium (ERP), which is a rolling 12-month total return for the S&P 500 minus the rolling 12-month total return for the Barclays Aggregate Bond Index. Around the end of last year and beginning of this year, the ERP broke above one standard deviation from the mean since 1977.

That suggests that maybe stock performance relative to bonds have been too impressive. In the past 30 years, six of the seven times that the ERP was close to or above one standard deviation, we slipped into a decline of 10 percent or more pretty soon after.

But there’s no guarantee that’s what’s going to happen this time. We could end up with a correction, but it could be in time rather than in price. Stocks could end up meandering sideways for quite some time, allowing the bond index’s total return to catch up to stocks, and as a result, bring that ERP back to the long-term average.

EQ: Last week, we saw the Dow hit a new all-time high. Just prior to that, you said you expected the S&P 500 to do the same in the near future. However, it’s doing this with an underperforming small-cap and Tech sector. What does that tell us about the current market’s uptrend?

Stovall: What that tells me is that the generals, in a sense, are the last ones to leave the battle field. If we are showing problems with the small-cap stocks and with some of the more higher-momentum areas, then I think it implies whatever new highs we reach in the larger cap indices like the Dow and the S&P 500, could be short lived.

Because if you don’t have breadth of participation then it could prove to be a new high that really does not have the support beneath it, and as a result, could end up falling should we be shaken by some unanticipated event.

EQ: Could a failure to break through the 1900 level potentially serve as a trigger to a pullback or correction?

Stovall: I don’t think the failure to break above 1900 would itself be a trigger, but rather a symptom of the lack of conviction. It would also be a double top, which from a technical perspective would be a topping pattern. So it would have to be something else that causes investors to move away from equities and it would be represented the lack of the ability to break above that 1900 level.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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