Bonds Versus Stocks
In the previous chapter, the inverse relationship between bonds and commodities was studied. In this chapter, another vital link will be added to the intermarket chain in order to study the positive relationship between bonds and common stocks and how to make money without any job search. The stock market is influenced by many factors. Two of the most important are the direction of inflation and interest rates. As a general rule of thumb, rising interest rates are bearish for stocks; falling interest rates are bullish. Put another way, a rising bond market is generally bullish for stocks. Conversely, a falling bond market is generally bearish for stocks. It can also be shown that bonds often act as a leading indicator of stocks. The purpose of this chapter is to demonstrate the strong positive linkage between bonds and stocks and to suggest that a technical analysis of stocks is incomplete without a corresponding analysis of the bond market.
Treasury bond futures, which have become the most actively traded futures contract in the world, were launched at the Chicago Board of Trade in 1977. In keeping with the primary focus on the futures markets, our attention in this chapter will be concentrated on the period since then, with special emphasis on the events of the 1980s. Toward the end of the book, a glance backward a bit further will reveal a larger historical perspective.
FINANCIAL MARKETS ON THE DEFENSIVE
As Chapter 3 suggested, the 1970s were a period of rising inflation and rising interest
rates. It was the decade for tangible assets. Bond prices had been dropping sharply
since 1977 and continued to do so until 1981. The weight of rising commodity prices
kept downward pressure on bond prices as the 1970s ended. During that decade, bond
market troughs in 1970 and 1974 preceded trading bottoms in the equity markets. A
bond market top in 1977, however, pushed stock prices lower that year and kept the
stock market relatively dormant through the end of the decade. In 1980 a major top in
the commodity prices set the stage for a significant bullish turnaround in bond prices
in 1981. This bullish turnaround in bonds set the stage for the major bull market in
stocks that started in 1982.
To put things in proper perspective, the period from 1977 to 1980 was also characterized by a falling U.S. dollar, which boosted inflation pressures and kept downward pressure on the bond market. The U.S. dollar bottomed out in 1980, which was mainly responsible for the bearish top in the commodity sector. The rising dollar in the early 1980s provided a supportive influence for financial assets like bonds and stocks and was mainly responsible for the swing away from tangible assets.
THE BOND MARKET BOTTOM OF 1981
AND THE STOCK BOTTOM OF 1982
The comparison of bonds and stocks will begin with the events surrounding the 1981
bottom in bonds and the 1982 bottom in stocks. Then a gradual analysis through the
simultaneous bull markets in both sectors culminating in the events of 1987 and 1989
will be given. Figures 4.1 and 4.2 are monthly charts of Treasury bonds and the Dow
FIGURE 4.1
MONTHLY CHART OF TREASURY BOND FUTURES FROM 1978 THROUGH SEPTEMBER 1989.
THE INDICATOR ALONG THE BOTTOM IS A 14 BAR SLOW STOCHASTIC OSCILLATOR. A
MONTHLY CHART IS HELPFUL IN IDENTIFYING MAJOR TURNING POINTS. TURNS IN THE
BOND MARKET USUALLY PRECEDE SIMILAR TURNS IN THE STOCK MARKET. THE BOTTOM IN
BONDS IN 1981 GAVE AN EARLY WARNING OF THE MAJOR BULL MARKET THAT BEGAN IN
STOCKS THE FOLLOWING YEAR. (SOURCE : COMMODITY TREND SERVICE, P.O. BOX 32309,
PALM BEACH GARDENS, FLORIDA 33420.)
MONTHLY CHART OF THE DOW JONES INDUSTRIAL AVERAGE FROM 1971 THROUGH SEPTEMBER 1989. THE INDICATOR ALONG THE BOTTOM IS A 14 BAR SLOW STOCHASTIC OSCILLATOR. MAJOR TRENDS IN THE STOCK MARKET USUALLY FOLLOW SIMILAR TURNS IN BONDS. THE STOCK MARKET BOTTOM IN 1982 AND THE PEAK IN 1987 WERE PRECEDED BY SIMILAR TURNS IN BONDS BY ELEVEN AND FOUR MONTHS, RESPECTIVELY. (SOURCE : COMMODITY TREND SERVICE, P.O. BOX 32309, PALM BEACH GARDENS, FLORIDA 33420.)
As the charts show, the period from 1977 to 1981 saw a falling bond market and a relatively flat stock market. From 1977 to early 1980 the downward pull of the bond market kept stocks in a relatively narrow trading range. In early 1980 a sharp bond rally began in March which helped launch a stock market rally the following month. The bond rally proved short-lived as prices began to drop again into 1981. After testing the upper end of its 14-year trading range, the Dow Industrials sold off again into 1982.
The bullish turnaround began in 1981. In September of that year, bonds hit their lowpoint and began a basing process that culminated in an important bullish breakout in August 1982. From September of 1981 to August of 1982, the bonds formed a pattern of three rising bottoms. Those three rising bottoms in bonds coincide with three declining bottoms in stocks. A major positive divergence was in place. As stocks continued to drop, the lack of downside confirmation by the bond market provided an early warning that a significant turn might be in progress.
August 1982 stands out as a milestone in stock market history. During that month, while many stock market traders were relaxing at the seashore, the great bull market of the 1980s began. During that month, the Dow Industrials dropped to a two-year low before recovering enough to register a bullish monthly reversal. At the same time bonds were breaking out from the basing pattern that had been forming for a year. After diverging from stocks for a year, the bullish breakout in bonds confirmed that something important was happening on the upside.
In Figures 4.1 and 4.2, notice the action of the stochastics oscillator during the bottoming process. The dotted line in the stochastics oscillator on the bond chart crossed above the solid line in the fall of 1981 from a level below 25, providing a buy signal in bonds. A similar buy signal in stocks didn't occur until the summer of 1982. The technical action in bonds preceded the bottom in stocks by almost a year. It should seem clear that stock market traders would have benefited from a technical analysis of bonds during that historic turnaround.