3 Things Worth Thinking About (Vol.18)

Stock/Bond Ratio Not Confirming Rally

Following the October swoon, stocks have vaulted to all-time highs. As I discussed previously in “Sentiment Is Off The Charts Bullish,” there have only been few occasions where investors have felt so “giddy” about the financial markets. Such periods of exuberance have never ended well for investors as they were deluded by near-term“greed” which blinded them to the building risks.

One of the things that I pay attention to is the ratio of the S&P 500 compared to longer duration bonds. The theory is that when investors are willing to take on more risk, money flows out of “safe haven” like bonds to equities as portfolio allocations become more aggressively tilted. The opposite occurs as investors began to reduce “risk exposure” in portfolios and focus more on “safety.”

As you can see in the chart below, there is a very high level of correlation between the rise and fall of the stock/bond ratio and the S&P 500. Well, that is until just lately.

Notice that currently, the ratio has deviated substantially from its normal correlation with the S&P 500 index. Importantly, this deviation began precisely when the Federal Reserve began extracting their liquidity support from the financial markets at the beginning of this year. With money rotating from “risk to safety” it is likely a clear warning that risks of a more substantial correction are building.

Given the economic slowdown globally, as discussed yesterday, rising deflationary pressures and elevated valuations it is highly likely that the majority of market gains have already been achieved. Furthermore, with the Federal Reserve now signaling that they are focused on raising interest rates, the tightening of monetary policy in an extremely weak economic environment will be a stronger headwind than currently anticipated.