Bonds and Equities, Why the Relationship has Faltered

Guest post contributed by Elizabeth Goldman on behalf of Sunbird FX

Traditionally, stocks and bonds have benefited from an inversely correlated relationship. When stocks are doing well, bonds tend to perform poorly and vice versa. However, over the last six months, the correlation between stocks and bonds has completely broken down.

Long equity positions on the NASDAQ have now reached 1.5 standard deviations, long bets on oil are near an extreme of 1.9 according to the Commodity Futures Exchange Commission. Compare this to the 10-year US Treasury at 1.96 percent. All of this signals a depression, deflation, or a deflationary depression a la the Great Depression.

The bears on the side of the argument believe that this is another 1972-73 moment. Fund manager John Hussman warned that indicators including a rise in the S&P500 by more than 8 percent above its 52-week moving average, a “Shiller price/earnings ratio” above 18, and bearish sentiment below 27 percent could send the market tumbling.

It’s also interesting to note that all market crashes from 1929 onward including the crashes of 1957, 1965-1966, 1972-73, 1986, 1987, 1998-2000, and 2007-08 had one technical indicator in common – the Expanding Megaphone. This pattern acts as a warning to anyone who is following technical indicators.

Add to this the fact that the Economic Cycle Research Institute (ECRI) indicated that its black-box forecasting method shows “pronounces, persistent and pervasive” signs that the U.S. is going to slide back into a recession.

It’s unclear whether the U.S. could handle another recession. Federal Reserve Chairman Ben Bernanke recently warned that the U.S. faces a “massive fiscal cliff” at the end of 2012. First, the Bush tax cuts are ending, $110 billion of spending is going to end due to “sequestration.” Increased Medicare taxes kick in. All of this is happening at once. Albert Edwards, from Societe Generale commented, “Every time the US economy falls below the stall speed at 1.75pc it falls into recession: we have now been below that for the last three quarters.”

In many ways, this is no different from the start of 2011. Corporate profits are sliding, not rising. They’ve peaked. That’s not going to be good for shareholders who jumped back into the market on the promises made by politicians that the economy was recovering. Like the Nikkei bubble, each rally in the market may be overpowered by a much stronger crushing force of debt deleveraging.

Europe appears to be committed to bailing out Greece as it becomes clear that Greece may need yet another bailout. Meanwhile, German lawyers are preparing a class-action lawsuit on behalf of 110 investors who want to sue banks for advising them to buy Greek debt. The bailouts and the lawsuits won’t be good for stocks.

Some Good News For Bondholders

The market will eventually have to make a choice. As faith in the stock market wanes, a flood of money could come pouring into the bond market or into the gold market. A new correlation could develop between stocks and gold or the old correlation between stocks and bonds could redevelop. Outside of that, a massive deflation via debt deleveraging would cause world stock markets to tumble. This could also temporarily hurt the bond market too, but bonds could hit the ground running on the other side of any market crash as people flock to safety.

Any bond issues that defaulted could be reissued as junk bonds posting higher yields, thus attracting investors to riskier markets to make up on the losses they previously suffered. After a deflation in the market, businesses can start to expand again thus giving more stability to the equity markets. Of course, it’s hard to say when that first domino will actually fall over. It’s in the process of falling right now. It just hasn’t hit the next domino in line yet.

Guest post contributed by Elizabeth Goldman, a freelance forex currency trading writer, on behalf of Sunbird FX – the experts in forex daily analysis, and home to the Sunbird metatrader platform.

All views and opinions expressed are those of the writer and do not necessarily represent Sunbird FX.

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