Philippine Stock Market Research

Bonds and Stocks Lose Their Inverse Relationship

August 23, 2011

As mentioned a lot of times before, bonds or fixed income securities and stocks or equities have an inverse relationship.  When the economy is doing well, investors flock to stocks, and inversely, when the economy is not doing so good, investors flock to bonds.  This is called flight to quality wherein investors seek the highest return for their capital with risk gauged on their minds.  This inverse relationship has held in the Philippines, and in the US, from 1881 to 1999, it has held also.

However, in the past decade in the US, for more than 100 years of an inverse relationship between stocks and bonds, the correlation between the two asset classes has become positive.  Stocks and bonds now have an 81% positive correlation.  In order to stimulate the economy, the Federal Reserve has lowered the federal funds rate, and because of that, bond yields have likewise decreased.  If bond yields go down, the US stock market should inversely go up.  However, the stimulus has done little for the economy that investors have not returned to stocks in a big way that will send the Dow or the S&P 500 roaring up.  Instead, we’ve had heightened volatility of 100 to 200 plus points swings of ups and downs in the stock market.

So in the flight to quality, where are funds going??  Gold and other precious metals have always been the parking slot of safety, and the surge in commodity prices inverse to the drop in stocks and bonds reflects that investors have preferred this asset class for their funds.  Is gold, the new bonds or stocks??  We don’t think this asset class compares to stocks or bonds.  55% of gold is used in jewelry and it does not produce long term returns compared to an emerging economy or country which the yields of its fixed-income securities will reflect or a growing listed company which its stock price will reflect.

We are living in extraordinary times.  If you think about the relationship between stocks and bonds becoming positive, you would be somewhat worried because fixed-income securities are supposed to be risk-free.  Suddenly, they’re moving with the direction of stocks, and that does not give a lot of comfort.  When the US economy recovers, the inverse relationship will return.  Now, however, investors have to be on their toes in their flight to quality.

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