In fact, the stock market and the bond markets have been moving in different directions for the past several months. This may be a clue that we are entering the late stages of an economic recovery. The correlation between stocks and bonds is not a foolproof signal of where we are in the cycle, but it is possible to make some generalizations.
Typically, at the top of the cycle (when things are going well), stock prices are rising due to higher corporate earnings but bond prices are falling as inflation fears surface and the Federal Reserve raises rates to prevent excesses. This tightening by the Fed didn’t happen in 2006/2007. As a result, the real estate market continued higher – into bubble territory. Absent this mistake by the central bank, what normally happens is that higher interest rates (lower bond prices) eventually cause the economy to slow down, but near the top of the market, rates are moving higher and so are stock prices.
At the very top, stocks begin falling in anticipation of a slowdown. Thus, at the very top of the cycle, the correlation between stocks and bonds reverses, where both bond prices are falling (interest rates are going higher) and stocks are also falling, indicating that a recession is around the corner.
After the cycle peaks, falling stocks confirm that corporate earnings are declining. As the recession gets worse, however, the banking authorities typically begin to lower rates in an attempt to restimulate the economy. Thus, going into the bottom of the cycle, stock prices are declining but bond prices start going up (interest rates decline). At this point, there is a negative correlation between stock prices and bond prices.
At the very bottom, theoretically, rising stock prices forecast an economic recovery a few months down the road, so at the very bottom the two markets re-sync. Both stock prices and bond prices are rising. Stock prices are forecasting recovery, while bond prices are rising (interest rates falling) because the central bankers are doing what they can to stimulate demand. In 2009, for example, stock prices rallied while the central bankers cut interest rates almost to 0%.
Since then, however, the cycle has moved on. Now the stock and bond markets are moving in opposite directions. Since last August, stocks have been moving up fast while bond prices have plunged (interest rates have increased sharply). The divergence, or “negative correlation” in statistics-speak, hasn’t been this extreme since 1956. I’m not exactly certain what this means, other than it’s a good bet that at some point in the near future the correlation will begin reversing direction, with stock returns and bond returns once again linked.
If interest rates start falling again (bond prices rising), then that could give stocks another shot in the arm. They, too, would be going up.
On the other hand, if rates continue to rise – which seems like a better bet to me – then bond prices will be falling. If the stock market syncs back up with bonds, then stocks would fall as well.
Right now, if rates keep going higher, we want the divergence (negative correlation) to continue for a bit longer. We probably want these late-cycle conditions to last as long as possible!
In the meantime, it is important to keep a close eye on where the business cycle is headed. We appear to be in a classic late-cycle expansion. In this stage, growth continues in spite of rising rates because they haven’t yet reached a high enough level to matter. Corporate profits are strong. Corporations are flush with cash. Certainly, the fact that banks are hording capital makes this cycle a bit different, but the general conditions of a late cycle expansion remain. Inflationary pressures are increasing, even if the government statistics don’t show it.
In the late cycle stages of an economic recovery, industrial and materials companies often do quite well. In recent months, our energy investments have been doing well. However, we have lacked exposure to the industrial economy in the portfolio. The fund we purchased owns companies like General Electric, United Technologies Corp., Caterpillar Inc., 3M Company, Union Pacific and Emerson Electric. These are companies that are benefitting from the weak dollar, increasing exports and taking advantage of the low cost of capital in both domestic and foreign markets.
Like our other recent purchase of a communications equipment fund, the investment in the industrial sector takes advantage of the dramatic return to corporate profitability engineered by the Federal Reserve’s commitment to bail out companies using both taxpayer and borrowed money. Businesses, more than consumers, have cash available to invest in equipment. Although capacity utilization is still fairly low, meaning that business doesn’t yet need to investment much in expansion, the CapU numbers have been improving steadily over the past two years and if that trend continues, it will eventually mean that businesses will once again invest in new plants and equipment.
For now, we appear to be in the late stages of expansion. These are typically robust times for business. As long as interest rates don’t go too high, too quickly, the good times can continue. While they are here, we want to be invested in the areas that are reaping the rewards. Nor do we want to take our eyes off the exits. This cycle won’t go on forever, and given its “late stage” characteristics, it is more important than ever to watch diligently for the time when the correlation between stocks and bonds reverses direction once again.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .
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