I often examine risk-off versus risk-on ratios to monitor the battle between economic fear and confidence. Or, in other words, bonds versus stocks.
For example, demand for bonds strengthened before the stock-market decline in 2008 (marked, below, as “A”). The same happened in spring 2010 (shown as “B”) and before August 2011 (“C”) — periods in which equities weakened. And bonds have outperformed stocks since the new year began (“D”).
Pay Attention to Price
There is a reason traders who focus on price are successful.
Price captures the aggregate opinion of all market participants about future economic outcomes, earnings, valuations, systemic risk, monetary policy, the Fed, etc.
As investors, we would prefer to reduce our exposure to stocks prior to, or in the early stages of, a sharp decline in prices while increasing our exposure to bonds. The chart below tracks investor demand for bonds (TLT) relative to stocks (SPY). When the ratio falls, it is indicative of demand for growth-oriented stocks and decreased interest in interest-bearing U.S. Treasuries.
Notice the ratio was making a series of lower highs and lower lows since 2008.
Rising fear of declines in stock prices was evident in the chart months before stocks actually dropped by sending out “be careful with stocks” signals.
What is the chart telling us at letter D? Bonds are rising in price, and stocks are falling in price.
The Big Picture for Returns
We would all, obviously, like to shift our capital from the stock bucket to the bond bucket before equities enter a bear market.
One way to assist us is to monitor the battle between economic conviction and economic fear, as shown by the chart above.
The fundamental rationale for monitoring the ratio of stocks (SPY) to bonds (TLT) is to prevent us from missing out on the next stock-market upswing that occurs every time after the bond/stock ratio peaks.
Like morning follows night, stock markets return to positive returns with bullish momentum based on increased earnings and economic growth favoring “risk-on” assets.
Individual investors, after being frightened to the safety of bonds, often miss out on the superior returns that stocks provide once the ratio changes.
The market’s pricing mechanism is saying to stay with bonds based on the early February chart favoring a “risk-off” position.
However, this ratio will change once again, and then you will want to be invested in stocks.