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Are equities going up or are they going down? 

This is the fundamental question we would all like to know before taking any action in the markets. 

Is now a good time to add risk or should I be pulling back? In finance and trading, we often refer to these two different environments as “risk on” and “risk off.” 

“Risk on” means that the mood of the market is one that believes that conditions are good for economic growth and positive market moves for equities. “Risk off” means there are concerns or conditions that could cause investors to pull out of markets, sending them lower.

This is a critical determination to make. There is so much data, many different market participants, and always some degree of uncertainty about the future. 

Over the years, traders and investors have made many attempts to try and identify which condition we are in. Because of their unique characteristics, the relationship between stocks and bonds were one of the first such attempts and it remains one of the most important pieces to this puzzle.

Stocks and Bonds: What’s the difference?

There are a lot of similarities between stocks and bonds, and a lot of differences. Both are types of investment vehicles where the investor or creditor expects to earn a rate of return on their investment, but how they earn that return and the relative risks of each are very different. 

Stocks represent an ownership stake in a company that gives the holders some rights to the companies profits, income (through dividends), or to affect company policies through voting on issues that come up. When the business is growing and becoming more profitable, the value of that share of the company will rise and if something happens to disrupt the business or reduce its profitability the value will fall and could go to zero. 

Corporate Bonds, instead of owning a piece of the company, are loans to a company that have to be repaid over time with interest. However, unlike a traditional loan, you can trade bonds (buy and sell). The bondholder expects to earn a modest rate of return on his investment related to the current interest rate plus a premium for the company-specific risks and has no further upside or claim to the success of the business. 

In the event of a bankruptcy or liquidation of the company, bondholders have the first claim to any remaining assets if available while stockholders would be unlikely to recover any of their initial investment. 

The safest bond issuers are generally stable governments (at least in theory). Governments are very large relative to corporations and have the ability to print money or levy taxes to fulfill their obligations. 

Since U.S. treasuries (TLT) are backed by the full faith and credit of the United States it provides assurance to bond holders that the expected interest payments and principal repayments will be made regardless of the economic situation.

The U.S. government is and has for a long time been considered one of the least risky bond issuers in the world. In fact, U.S. bonds are generally considered “risk-free.”  Therefore, we use U.S. government bonds (TLT) here to help determine the current market environment.

Risk On Versus Risk Off

The relationship between the demand for lowest risk bonds (U.S. Treasuries) and the demand for higher-risk stocks (S&P 500) is a great proxy for the overall market sentiment. 

When investors are optimistic about the economy and the prospects for growth, demand for stocks, which have more upside than bonds, will increase compared to demand for less risky and less profitable U.S. treasuries on a relative basis and vice versa. We can monitor this relationship with a ratio chart. 

Ratio charts compare two financial instruments against each other and show which one is outperforming on a relative basis. The chart is created by dividing the daily closes of one instrument against the other. Most trading platforms support this type of chart.

The chart above shows the ratio between U.S. Bonds (TLT ) and S&P 500 ETF (SPY). The red line in the upper box is the ratio. The red ratio line will move up when SPY is outperforming TLT and will move down when SPY is underperforming TLT

By adding a moving average to the ratio, we can further improve our ability to see significant or important changes in the ratio (relative value) of the two instruments. The dark-blue line is the 125-day average of that ratio and the black is the 20-day average.  

When the ratio is above its moving average, we are in a “bullish” or “risk on” condition, and when the ratio is below its moving average, we are in a “bearish” or “risk off” condition.

If we take this ratio and overlay the bullish and bearish ratio sentiment on a chart of the SPY ETF, we can see when this intermarket relationship was telling you to be bullish and when it was telling you to be bearish.

The chart above shows the performance of the bearish and bullish sentiment of this ratio during the worst periods of the 2008 financial crisis and eventual transition into recovery in 2009. While it didn’t get every move correct, following this ratio could have helped you avoid most of the drop in the markets and ensured you were correctly positioned for the recovery not too far off the eventual lows. 

The 2008-09 financial crisis was a major decline that, fortunately, isn’t too common in markets, though markets frequently feature smaller corrections. The stocks vs. bonds ratio also navigated many of the these smaller corrections nicely. 

The chart above shows a period from early 2015 through early 2016 where, while the market ended this period mostly flat, you would have had to sit through two corrections that each were nearly -15%. The stocks vs bonds ratio shifted to bearish early enough to give you warning before either of these declines.

Because of their unique properties, the ratio between stocks and bonds continues to be one of the most important investment metrics to watch. Understanding how they relate to each other and how to interpret their relative changes in value can help us steer clear of the shoals or  know when there is smooth sailing ahead.

Keith Schneider is the CEO of Marketguauge. He started out as one of the youngest floor traders in 1982.