DoesThe Bond Market Predict Market Bottoms?

I have received a number of comments that indicate some degree of confusion about what I said in my article: Do Bonds Predict Market Bottoms? The basic question is that, if bond traders are human (a given), and if humans are fallible, then how can bond traders predict the bottom. But, if you read my article carefully, you will see that that is not what I said! As a matter of fact, I said just the opposite.

So now let's review the topic. But first, I need to state some basic facts so that we're all on the same page.

1. Historically, over a long period of time, the S&P 500 has returned a 6 to 7% yield per annum.
2. The Fed has stated its intention to keep inflation between 1 and 2%.
3. Therefore, any long term investment goal would be to keep your total yield significantly above inflation. In this case, above 2%.
4. If inflation rises, you will, of course, require higher yields.
5. Currently, the 10 year US Treasury bond is yielding about 3.93% and the 30 year US Treasury Bond is yielding about 4.23%.
6. These are the benchmarks. Municipal bonds will have to offer a higher yield. This, in the case of quality municipal bonds is on the order of one to two percent higher. Corporate bonds have to offer even higher yields.
7. The poorer the quality of the municipality or corporation, the higher the yields they must offer in order to attract investors (think "junk bonds").
8. You must look forwards and try to anticipate future inflation rates. Therefore, it would be prudent to try to get at least 2% above the current rate of inflation, in order to give yourself some leeway.
9. The longer the period of commitment, the greater the risk that inflation will rise enough to wipe out your returns. Therefore, the longer the period of the bond, the higher the yield that will be required.
10. Bond prices and yields move in opposite directions. As bond prices fall, bond yields rise.
    

OK. Now let's look at the current situation. With yields of 3.93% and 4.23%, there seems to be no justification for committing your money for an extra 20 years. So I will focus on the 10 year Treasury bond. At this yield, you are getting a paltry 1.93% rate of return above a 2% inflation rate. If inflation rises by 1%, you are basically at break-even. If it rises by a further 1% (to 4% per year), you are losing money.

Remember that bonds are sold at auction. The price is determined by the balance between buyers and sellers. If you have an imbalance like, say an excess of sellers or a dearth of buyers, then bond prices will fall. And, of course, bond yield will rise.

Now let's look at the stock market. It has dropped so much that many corporate dividends have risen up to 3% or better. And the P/E's of those corporations have also dropped. (See Bespoke article on P/E ratios.) Thus, you have a good dividend rate plus the potential for capital appreciation if those corporations return to their historical P/E ratios. These bluest of the blue chips are thus starting to look attractive. Especially so when you look at the current bond yields. Remember that, historically, the S&P 500 has returned 6 to 7% per year. Thus, to remain committed to bonds at these current yield levels means that you are committed to lower than historically attainable yields. You may make an individual decision to do so, based to your level of risk aversion and the current scary market conditions. But no money manager can afford to take that cavalier an attitude and allow his fund to fall that far behind the competition. He must find some way to improve his rate of return beyond a point or so above inflation!

And so, faced with such low yields, money managers, in their quest for better yields, must look elsewhere than at bonds. And that means stocks. As I said, they will start off by looking at core companies with good dividends, low P/E ratios and that are "recession proof." And so they start to make cautious allocations to these stocks. And, as more and more money managers start to shift their allocations, bond prices start to drift downwards, due to the lack of buyers. And so this is where the observation that the bond market (not bond traders) predicts market bottoms by on average, six months. That is why I recommended watching bond prices. When bond prices establish a trend downwards (yields are rising), then that is the signature of money starting to shift out of bonds and into stocks.

BTW. When you see 10 year bond yields at 5 or 6% and 30 year bond yields at 6 to 7% or higher, then that usually means that the stock market is "frothy."(Assuming that inflation is stable at 1 to 2%, of course.) At that point, bonds become extremely attractive and money starts to flow back into bonds. That reduces the amount of money available to continue to pump up the stock market. And once again, the bond market will "predict" the future course of the stock market. It doesn't, of course. It's just basic economics: Get the best and safest yield that you can. And stay above the rate of inflation.