Bonds And Stocks Should Be Analyzed Together
The moral of this chapter is that since bonds and stocks are historically linked together, technical analysis of one without a corresponding analysis of the other is incomplete as the experts on job search sites, e-books, books, etc usually say. At the very least a stock market trader or investor should be monitoring the bond market for confirmation. A bullish technical forecast for bonds is also a bullish technical forecast for stocks. Conversely, a bearish analysis for bonds is a bearish forecast for stocks. As demonstrated in Figures 4.1 and 4.2, the technical signals in bonds (such as stochastics buy and sell signals) usually lead similar signals in stocks. At the worst the signals are usually coincident. Analysts can use moving averages or any other tools at their disposal. The important thing is that bond activity be factored into the stock market analysis.
WHAT ABOUT LONG LEAD TIMES?
Although the charts of recent market history show a remarkable day-to-day correlation
between bonds and stocks, turns in the bond market often lead those of stocks by
long periods of time. The September 1981 bottom in bonds, for example, preceded
the stock market bottom in August 1982 by 11 months. The April 1987 breakdown
in bonds preceded the August stock market top by four months. How, then, does the
stock market analyst take these long lead times into consideration?
The bond market is an important background factor in stock market analysis. Buy and sell signals for stocks are given by the stock market itself. If the bond market starts to diverge from the stock market, a warning is being given—-the more serious the divergence, the more important the warning. In the summer of 1987, as an example, the collapse in the bond market simply warned the stock market trader that something was wrong. The stock market trader, while not necessarily abandoning long positions in stocks during the summer of 1987, might have paid greater attention to initial signs of impending weakness on his stock charts.
In 1981 and 1982 the bottoming action in the bond market gave the stock market traders plenty of warning that the tide might be turning. Even if the stock trader ignored the bottoming activity in bonds up to the summer of 1982, the bullish breakout in bonds in August of 1982 might have caused a stock market trader to become more aggressive in buying into the stock market rally. The long lead times in both instances, while less helpful to the short-term trader, were probably most useful to portfolio managers or those investors with a longer time horizon.
Having acknowledged the existence of occasional long lead times between the two markets, it should also be pointed out that on a day-to-day basis there is often a remarkable correlation between the two markets. This correlation can even be seen on an hour-to-hour basis on many days. Even for short-term timing, it's a good idea to monitor the activity in the bond market.
SHORT-TERM INTEREST RATE MARKETS AND THE BOND MARKET
Our main concern has been with the bond market. However, for reasons that were
touched on in Chapter 3, it's also important to monitor the trend action in the Treasury
bill and Eurodollar markets because of their impact on the bond market. Action
in these short-term money markets often provides important clues to bond market
direction.
During periods of monetary tightness, short-term interest rates will rise faster than long-term rates. If the situation persists long enough, short-term rates may eventually exceed long-term rates. This condition, known as an inverted yield curve, is considered bearish for stocks. (The normal situation is a positive yield curve, where long-term bond yields exceed short-term market rates.) An inverted yield curve occurs when the Federal Reserve raises short-term rates in an attempt to control inflation and keep the economy from overheating. This type of situation usually takes place near the end of an economic expansion and helps pave the way for a downturn in the financial markets, which generally precedes an economic slowdown or a recession.
The action of short-term rate futures relative to bond futures tells whether or not the Federal Reserve Board is pursuing a policy of monetary tightness. In general, when T-bill futures are rising faster than bond futures, a period of monetary ease is in place, which is considered supportive to stocks. When T-bill futures are dropping faster than bond prices, a period of tightness is being pursued, which is potentially bearish for stocks. Another weapon used by the Federal Reserve Board to tighten monetary policy is to raise the discount rate.