Bonds As a Leading Indicator Of Stocks

The purpose of this chapter is twofold. One is to demonstrate a strong positive relationship between bonds and stocks. In other words, the price action and technical readings in the two markets should confirm each other. As long as they are moving in the same direction, analysts can say that the two markets are confirming each other and their trends are likely to continue. It's when the two markets begin to trend in opposite directions that analysts should begin to worry.

The second point is that the bond market usually turns first. Near market tops, the bond market will usually turn down first. At market bottoms, the bond market will usually turn up first. Therefore, the technical action of the bond market becomes a leading technical indicator for the stock market.

The young bull market in bonds and stocks continued into early 1983. In May of 1983, however, the bond market suffered a bearish monthly reversal, setting up a potential double top on the bond chart (see Figure 4.1). At the same time, the stochastics oscillator gave a sell signal. As Figure 4.2 shows, stocks began to roll over toward the end of 1983 and flashed a stochastics sell signal as the year ended. The setback in stocks wasn't nearly as severe as that in bonds. However, the weakness in bonds warned that it was time to take some profits prior to the 15 percent stock market decline.

In mid-1984 both markets flashed new stochastics buy signals at about the same time. (Bonds actually began to rally a month before stocks.) The beginning of the second bull leg in the bond market had a lot to do with resumption of the bull market in stocks. Both markets rallied together for another two years. It wasn't until early 1987, when the two markets began to move in opposite directions, that another negative divergence was given.

hi April 1987 bonds began to drop (flashing a stochastics sell signal), which set the stage for the 1987 stock market crash in October of that year. Once again the bond market had proven its worth as a leading indicator of stocks. The bullish monthly reversal in bonds in October 1987 also set the stage for the stock market recovery from the 1987 bottom. A stochastics buy signal in bonds at the end of 1987 preceded a similar buy signal in stocks by almost a year. During the entire decade of the 1980s, every significant turn in the stock market was either accompanied by or preceded by a similar turn in the bond market.

Overlay charts will show comparison of the relative action of bonds and stocks over shorter time periods. On the monthly charts used in preceding paragraphs, price breakouts and stochastics buy and sell signals were emphasized. In the overlay charts, attention will shift to relative price action. Price divergences are easier to spot on overlay charts, and the leads and lags between the two markets are more obvious.

Figure 4.3 compares the two markets from 1982 through the third quarter of 1989. The similar trend characteristics of the two markets are more easily seen. The most prominent points of interest on this chart are the simultaneous rallies in 1982; the breakdown in bonds in 1983 leading to a stock market correction; the simultaneous

FIGURE 4.3
A COMPARISON OF TREASURY BONDS AND STOCKS FROM 1982 TO 1989. ALTHOUGH BOTH MARKETS GENERALLY TREND IN THE SAME DIRECTION, BONDS HAVE A TENDENCY TO TURN AHEAD OF STOCKS. BONDS SHOULD BE VIEWED AS A LEADING INDICATOR FOR STOCKS.

A COMPARISON OF TREASURY BONDS AND STOCKS FROM 1982 TO 1989. ALTHOUGH BOTH
MARKETS GENERALLY TREND IN THE SAME DIRECTION, BONDS HAVE A TENDENCY TO TURN
AHEAD OF STOCKS. BONDS SHOULD BE VIEWED AS A LEADING INDICATOR FOR STOCKS

upturn in both markets in 1984; the top in bonds in early 1987, preceding the stock market crash of 1987; and both markets rallying together into 1989. To the upper right it can be seen that the breakout by stocks above their 1987 pre-crash highs has not been confirmed by a similar bullish breakout in bonds.

Figures 4.4 through 4.9 break the period from 1982 to 1989 into shorter time intervals to provide closer visual comparisons. I'll take a closer look at the events immediately preceding and following the October 1987 stock market crash and will also examine the market events of 1989 in more detail. Figure 4.4 shows the relative action of bonds and stocks at the 1982 major bottom. Notice that as the Dow Industrials hit succeeding lows in March, June, and August of 1982, the bond market was forming rising troughs in the same three months. In August, although both markets rallied together, bonds were the clear leader on the upside.

FIGURE 4.4
A COMPARISON OF BONDS AND STOCKS DURING 1982 AND 1983. BONDS TURNED UP PRIOR TO STOCKS IN 1982 AND CORRECTED DOWNWARD FIRST DURING 1983.

A COMPARISON OF BONDS AND STOCKS DURING 1982 AND 1983. BONDS TURNED UP
PRIOR TO STOCKS IN 1982 AND CORRECTED DOWNWARD FIRST DURING 1983

In May of 1983, bonds formed a prominent double top and began to drop. That bearish divergence led to an intermediate stock market peak at the end of the year, which led to a 15 percent downward correction in the equity market. The downward correction in both markets continued into the summer of 1984 (see Figure 4.5). A stocks by almost a month. Both entities then rallied together through the end of 1985. Notice, however, that short-term tops in bonds in the first quarter and summer of 1985 preceded downward corrections in the stock market.

FIGURE 4.5
BONDS VERSUS STOCKS DURING 1984 AND 1985. BONDS TURNED UP A MONTH BEFORE STOCKS IN 1984. DURING 1985 TWO DOWNWARD CORRECTIONS IN TREASURY BONDS WARNED OF SIMILAR CORRECTIONS IN EQUITIES.

BONDS VERSUS STOCKS DURING 1984 AND 1985. BONDS TURNED UP A MONTH BEFORE
STOCKS IN 1984. DURING 1985 TWO DOWNWARD CORRECTIONS IN TREASURY BONDS
WARNED OF SIMILAR CORRECTIONS IN EQUITIES

Figure 4.6 compares the two markets during 1986 and 1987. After rising for almost four years, both markets spent 1986 in a consolidation phase. However, at the beginning of 1987, stocks resumed their bull trend. As the chart shows, bonds did not confirm the bullish breakout in stocks. What was even more alarming was the bearish breakdown in bonds in April of 1987 (influenced by a sharp drop in the U.S. dollar and a bullish breakout in the commodity markets). Stocks dipped briefly during the bond selloff. During June the bond market bounced a bit, and stocks resumed the uptrend. However, bonds broke down again in July and August as stocks rallied. You'll notice that bonds broke support at the May lows in August, thereby flashing another bear signal. This bear signal in bonds during August 1987 coincided with the 1987 peak in stocks the same month.

FIGURE 4.6
BONDS VERSUS STOCKS DURING 1986 AND 1987. BONDS COLLAPSED IN APRIL OF 1987 AND PRECEDED THE AUGUST PEAK IN STOCKS BY FOUR MONTHS.

BONDS VERSUS STOCKS DURING 1986 AND 1987. BONDS COLLAPSED IN APRIL OF 1987
AND PRECEDED THE AUGUST PEAK IN STOCKS BY FOUR MONTHS

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Contents Bonds As a Leading Indicator Useful links Good Investment	Bonds As a Leading Indicator Of Stocks Bonds As a Leading Indicator Of Stocks The purpose of this chapter is twofold. One is to demonstrate a strong positive relationship between bonds and stocks. In other words, the price action and technical readings in the two markets should confirm each other. As long as they are moving in the same direction, analysts can say that the two markets are confirming each other and their trends are likely to continue. It's when the two markets begin to trend in opposite directions that analysts should begin to worry. The second point is that the bond market usually turns first. Near market tops, the bond market will usually turn down first. At market bottoms, the bond market will usually turn up first. Therefore, the technical action of the bond market becomes a leading technical indicator for the stock market. The young bull market in bonds and stocks continued into early 1983. In May of 1983, however, the bond market suffered a bearish monthly reversal, setting up a potential double top on the bond chart (see Figure 4.1). At the same time, the stochastics oscillator gave a sell signal. As Figure 4.2 shows, stocks began to roll over toward the end of 1983 and flashed a stochastics sell signal as the year ended. The setback in stocks wasn't nearly as severe as that in bonds. However, the weakness in bonds warned that it was time to take some profits prior to the 15 percent stock market decline. In mid-1984 both markets flashed new stochastics buy signals at about the same time. (Bonds actually began to rally a month before stocks.) The beginning of the second bull leg in the bond market had a lot to do with resumption of the bull market in stocks. Both markets rallied together for another two years. It wasn't until early 1987, when the two markets began to move in opposite directions, that another negative divergence was given. hi April 1987 bonds began to drop (flashing a stochastics sell signal), which set the stage for the 1987 stock market crash in October of that year. Once again the bond market had proven its worth as a leading indicator of stocks. The bullish monthly reversal in bonds in October 1987 also set the stage for the stock market recovery from the 1987 bottom. A stochastics buy signal in bonds at the end of 1987 preceded a similar buy signal in stocks by almost a year. During the entire decade of the 1980s, every significant turn in the stock market was either accompanied by or preceded by a similar turn in the bond market. Overlay charts will show comparison of the relative action of bonds and stocks over shorter time periods. On the monthly charts used in preceding paragraphs, price breakouts and stochastics buy and sell signals were emphasized. In the overlay charts, attention will shift to relative price action. Price divergences are easier to spot on overlay charts, and the leads and lags between the two markets are more obvious. Figure 4.3 compares the two markets from 1982 through the third quarter of 1989. The similar trend characteristics of the two markets are more easily seen. The most prominent points of interest on this chart are the simultaneous rallies in 1982; the breakdown in bonds in 1983 leading to a stock market correction; the simultaneous FIGURE 4.3 A COMPARISON OF TREASURY BONDS AND STOCKS FROM 1982 TO 1989. ALTHOUGH BOTH MARKETS GENERALLY TREND IN THE SAME DIRECTION, BONDS HAVE A TENDENCY TO TURN AHEAD OF STOCKS. BONDS SHOULD BE VIEWED AS A LEADING INDICATOR FOR STOCKS. upturn in both markets in 1984; the top in bonds in early 1987, preceding the stock market crash of 1987; and both markets rallying together into 1989. To the upper right it can be seen that the breakout by stocks above their 1987 pre-crash highs has not been confirmed by a similar bullish breakout in bonds. Figures 4.4 through 4.9 break the period from 1982 to 1989 into shorter time intervals to provide closer visual comparisons. I'll take a closer look at the events immediately preceding and following the October 1987 stock market crash and will also examine the market events of 1989 in more detail. Figure 4.4 shows the relative action of bonds and stocks at the 1982 major bottom. Notice that as the Dow Industrials hit succeeding lows in March, June, and August of 1982, the bond market was forming rising troughs in the same three months. In August, although both markets rallied together, bonds were the clear leader on the upside. FIGURE 4.4 A COMPARISON OF BONDS AND STOCKS DURING 1982 AND 1983. BONDS TURNED UP PRIOR TO STOCKS IN 1982 AND CORRECTED DOWNWARD FIRST DURING 1983. In May of 1983, bonds formed a prominent double top and began to drop. That bearish divergence led to an intermediate stock market peak at the end of the year, which led to a 15 percent downward correction in the equity market. The downward correction in both markets continued into the summer of 1984 (see Figure 4.5). A stocks by almost a month. Both entities then rallied together through the end of 1985. Notice, however, that short-term tops in bonds in the first quarter and summer of 1985 preceded downward corrections in the stock market. FIGURE 4.5 BONDS VERSUS STOCKS DURING 1984 AND 1985. BONDS TURNED UP A MONTH BEFORE STOCKS IN 1984. DURING 1985 TWO DOWNWARD CORRECTIONS IN TREASURY BONDS WARNED OF SIMILAR CORRECTIONS IN EQUITIES. Figure 4.6 compares the two markets during 1986 and 1987. After rising for almost four years, both markets spent 1986 in a consolidation phase. However, at the beginning of 1987, stocks resumed their bull trend. As the chart shows, bonds did not confirm the bullish breakout in stocks. What was even more alarming was the bearish breakdown in bonds in April of 1987 (influenced by a sharp drop in the U.S. dollar and a bullish breakout in the commodity markets). Stocks dipped briefly during the bond selloff. During June the bond market bounced a bit, and stocks resumed the uptrend. However, bonds broke down again in July and August as stocks rallied. You'll notice that bonds broke support at the May lows in August, thereby flashing another bear signal. This bear signal in bonds during August 1987 coincided with the 1987 peak in stocks the same month. FIGURE 4.6 BONDS VERSUS STOCKS DURING 1986 AND 1987. BONDS COLLAPSED IN APRIL OF 1987 AND PRECEDED THE AUGUST PEAK IN STOCKS BY FOUR MONTHS.
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