What Bonds Are Saying About The Next Stock Plunge

By Hans Wagner | April 08, 2010 AAA

Many investors believe bond traders understand the economy better than equity traders. Bond traders pay very close attention to any economic factor that might affect interest rates. Equity traders recognize that changes in bond prices provide a good indication of what bond traders think of the economy. Since equity traders worry about many other factors that might affect the price of any equity, including corporate malfeasance, they tend to depend on bond traders to give them a heads up on economic issues.

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Since the global bond market is more than twice the size of the world's equity markets, equities traders pay attention to what bond traders see. Bond prices tend to rise and interest rates fall when greater perceived risk looms. Many portfolio managers will move money from stocks to bonds if they see greater risk on the horizon. Transferring cash from stocks to bonds adds to the downward pressure on stock prices. At some point, the bond rally will end and money will flow back to equities. Is the rally in bond prices telling us stock prices will continue down?

Bond Prices Rally, Stocks Fall
The plunge in the markets accompanied the rally in bond prices, as many investors bailed out of stocks seeking safety in bonds, especially Treasuries. Some investors believe bond traders are "smarter" than stock traders, as bond traders focus on the economy and the role of interest rates more closely. But is the rally in bond prices telling us stock prices will continue to fall?

As long as investors fear the risk of a major economic slowdown, they will seek the safety of high-quality bonds and Treasuries. Rather than seek higher yield accompanied with higher risk, they are willing to receive less income in return for lower risk of losing their principal investment. This is what happened in the beginning of April, when high-grade bonds began their rally. Bond investors sought safety, fearing that the Greek credit crisis would become a major meltdown. This fear continues causing the higher volatility in the equity markets that we are experiencing, which increases risk to investors. (For a look into the Greek crisis, check out Greece: By The Numbers.)

High-grade bonds and Treasuries will tend to outperform the move by lower quality bonds when investors are seeking safety. One quick way to view this is to compare the performance of investment-grade corporate bonds with that of high yield corporate bonds. When bond investors believe that the risk trade is ending, they will begin to move their money into higher yielding and riskier debt securities. Until then the equity markets will remain volatile.

Getting Back to Stocks
With all the money that has moved into bonds and out of stocks, you might be wondering how you can tell when to get back into stocks. After all, drops in the market sometimes offer the best buying opportunities, as long as the trend does not continue down. Like so many things, the answer is, it depends. In this case, it depends on bond traders' view of risk. (They may not be sexy, but bonds offer undeniable benefits to investors. For more on bonds, read Savings Bonds For Income And Safety.)

What to Look For
Fear of economic troubles leads bond investors to forsake higher yield for the safety of their principal. As long as they believe the economy is weak and risk of a meltdown remains, they will remain in their safer investments. At some point, the risk of the economy will diminish and we will see demand for low quality bonds rise as investors seek higher yield. This is a signal to equity investors to get back into the market and own stocks.

Get a rundown of the latest financial news in this week's Water Cooler Finance: Buffett Buzz, Toxic CDOs And Facebook Privacy.

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