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. At the same time, the stochastics oscillator gave a sell signal. Data 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.
Data 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 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.
Data show 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. Data 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.
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. A close inspection of Figure 4.5 will show that the mid-1984 upturn in bonds preceded 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.
Data 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.
Bonds not only led stocks on the downside in the fall of 1987, they also led stocks on the upside. Figure 4.7 shows the precipitous slide in bond prices which preceded the stock market crash in October 1987. The bearish breakdown in bonds was too serious to be ignored by stock market technicians. However, as the actual stock market crash began, the bond market soared in a flight to quality. Funds pulled out of the stock market in panic were quickly funneled into the relative safety of Treasury bills and Treasury bonds. There was another important factor that helps explain the sharp rally in interest rate futures in October 1987.
In the ensuing panic during the stock market crash, the Federal Reserve flooded the financial system with liquidity in an attempt to calm the markets and cushion the stock market fall. At the time the consensus view was that a serious recession was at hand. As a result the sudden monetary easing pushed interest rates sharply lower. The lowering of interest rate yields pushed up the prices of interest rate futures.
At such times the normal positive relationship of bonds and stocks is temporarily disturbed. Until the markets stabilized, an inverse relationship between the two sectors was evident. However, as Figure 4.7 shows, that inverse relationship was shortlived. In fact, it's remarkable how quickly the positive relationship was resumed. Within a matter of days, the peaks and troughs in bonds and stocks begin to move in the same direction. However, the sharp rally in bonds into the first quarter of 1988 reflected continued concerns about an impending recession (or depression) and the desire on the part of the Federal Reserve Board to lower interest rates to prevent such an eventuality.
By the middle of 1988, things seemed pretty much back to normal. However, through it all, on the downside first and then on the upside, important directional clues about stock market direction during the summer and fall of 1987 could be discovered by monitoring the bond market.
Data gives us a view of 1988 and the first three quarters of 1989. It can be seen that from the spring of 1988 to the fall of 1989, the peaks and troughs in both sectors were closely correlated and that both markets rallied together. However, in this instance the stock market proved to be the stronger of the two. Although both markets moved in the same direction, it wasn't until May of 1989 that bonds finally broke out to the upside to confirm the stock market advance.
Data gives a closer look at 1989. This chart shows the close visual correlation of both markets. The timing of the peaks and troughs is extremely close together. To the upper right, however, the bond market is beginning to show some signs of weakness in what could be the beginning of a negative divergence between the two markets. Read More : Bonds As A Leading Indicator Of Stocks
