In one sense, a lot of investors are seriously confused by the interaction between the bond market and the stock market in this way. It is really pretty unclear how changes in interest rates are going to affect the stock price or what might be done to benefit from those changes. Should the prices of bonds rise or fall, should one act on it or is this somehow more complicated? Unless some sort of strategy is devised then the ebbs and flows of these markets could only be missed opportunities or even losses without any sort of strategy.
This concept takes the idea a step further as to how the bond to stocks relationship can actually be pretty convoluted and displays how movement in the bond market, more specifically long-term Treasury bonds via the TLT ETF, can have an actual deep effect on the price of stocks-an S&P 500 ETF, or SPY. Let’s dive in together to understand how these interest rates, influenced by bond prices, can help investors make better decisions on when to buy and sell in the stock market.
Here we introduce a tested, back-tested strategy that uses the movements of the bond market to give optimal times for the trading of stocks. The basis of this solution is technical indicators of the bond market: simple, such as in the 15-day moving average. So an intrinsic relation between bonds and stocks toward enhancing returns and minimizing risks could be tapped into. Now let’s see how this strategy works on historical back-testing and empower you to apply it to your own investment approach.
It can help us know how stocks will respond to higher bond prices if we learn some of the very simple principles of bond pricing and interest rates. The latter is pretty amazing: it’s a negative relationship. Bond price increases, yields-interest rates-go down. And vice versa. That’s a really important relationship because it has a pretty direct impact on where the relative attractiveness is: stocks versus bonds.
Interest Rates and Stocks:
Stocks are usually a riskier investment than bonds. The reason is that bonds rank ahead of in bankruptcy or liquidation, so they must be less risky in their own right. When interest rates are low, on average, the pay on bonds is less than on stocks, and higher returns may draw investors to stocks. On the other hand, in a high interest rate economy, bonds have relatively more competitive prices when compared to stocks because at high interest rates, people turn their attention to the relatively safer bonds.
Bond Prices and Stock Prices:
The prices of bonds inversely correlate with the interest rates. Generally speaking, an increase in interest usually brings about falling prices for bonds and lower interest rates become a preferable choice for stocks. If bond prices are generally falling, then it generally means that interest rates are going to rise, and the outlook for stocks is pretty terrible, in general.
**Why Focus on Bonds?
The bond market is a good leading indicator that provides you with at least some hints on where the stock market will move into the future. Here’s something you can do to really take the big leap forward by tracking the changes within the longer-term prices for bonds, such as the 20-year Treasury bond-often referred to as TLT. Any information on when bonds are going to go up or down is going to provide the investor with an opportunity to fine-tune his or her exposure to the stock market.
The Back-Tested Strategy: Buy Stocks When Bonds Rise End
This one is quite obvious but extremely powerful if done right. This strategy is trading the SPY relative to the movements of the long term United States Treasury Bond ETF, TLT. The strategy buys stocks when TLT is above its moving average and sells when it falls below the moving average.
Key Elements of Strategy:
- TLT and SPY:
- SPY: Tracks the S&P 500, so this ETF represents a broader piece of the U.S. stock market.
- TLT: Tracks U.S. 20-year Treasury bonds. When TLT rises, bond yields fall. This typically means potentially lower interest rates and a more positive environment for stocks.
Moving Average: It is a price technical indicator that smooths out prices over specified periods. We will be using a 15-day moving average of TLT in generating our buy and sell signals on SPY.
Buy Signal: When SPY closes above its 15-day moving average.
-Sell Signal: When TLT falls below its 15-day moving average, we sell SPY and go to cash or some low-risk investment
-Back Test Results:
We have back-tested this strategy since 2003 forward. What we learned from the results is as follows:
- Consistency of Gains:
The strategy has consistently beaten random trading periods. For moving averages of 5- to 100-day lengths, on average the gain per trade was higher when TLT was above its moving average. That is, on average, stocks were relatively better when bonds went up-or-when TLT was above its moving average.
2. Annual Return:
We calculated the annual return of 8.85% based on the use of the 15-day moving average from year 2003 through to date. This is 0.95% points inferior to the average annual return of S&P 500 for the same period, but one should note that the strategy was only invested in on 54% of days. From here what can be taken back is that even at less than full investment competitive returns came at risk management.
3. Drawdown Management:
The strategy max drawdown was at 31%. This would likely be a bit higher than what many investors would like to see. However, I must point out that it is only a benchmark for long-term equities. The strategy only draws back the equities in less favorable bond market environments.
Key Lessons and Recommendations Learned
Stock-Bond Relations:
Obviously, a test from our back comes up with the fact that in the case of a reduction in interest rates, even rising inflations in bond prices go on to inflate stock prices. Utilizing the simple technical indicators such as TLT’s moving average, one may catch up with such dynamics in order to enhance returns from the stock markets.
Optimal Market Timing
This is, in fact, the most powerful advantage because it is quite obvious: its underpinning for avoiding the trap of trying to time markets and becoming disciplined in the investment approach is based on using a rule-based approach that immediately responds to the signals received from the bond markets.
- Risk-Reward Trade-Off:
Although the strategy does involve spending some time out of the market, the return per trade and lower time in the market are such that investors can reduce their risk exposure while still obtaining very good returns. Results from back-testing do suggest that this approach often outperforms a random approach over time. - When to Avoid Stocks:
When TLT begins to decline below its moving average, it is the time to reduce one’s exposure to stocks and look to safer investments. General theory forms the basis of which dictates that stocks perform weakly in a rising interest rate environment.
Conclusion: Stocks Rise When Bonds Rise
As a conclusion of our back test we find out that there is a strong interaction between the two prices: the stocks tend to do well if the trend is upward in bonds. The idea behind it is easy to apply: the price of longterm Treasury bonds could be used in a simple moving average strategy so that a trader could keep an eye on the bond prices and spot opportune times for being within the stock market.
This approach provides a systematic, data-based approach to the timing of equity market entry and exit based on bond market moves. The strategy does not guarantee a profit and will allow cash holding periods. It will, however, provide a systematic approach by which the returns from the stock can possibly be improved and risk reduced. Are you an investor wanting to enhance your portfolio? If you wish to win, you’d do well by watching on the bond prices and interest rates.