(Bloomberg) -- It's not how low you go, it's how fast you fall.
That, in a nutshell, is the logic behind a bond market signal for stock investors that shows the deterioration in credit may be happening too fast for equities to withstand. The indicator, Leuthold Group's Dow Bond Oscillator, just flashed a reading that has spelled trouble for equities before, and may have bitten Tuesday as the S&P 500 slid the most since August.
It's a different take on how the two markets interact, at odds with those who point to the absolute altitude of yields -- such as the present 2.7 percent in 10-year Treasuries -- as the main impediment for stocks. To Doug Ramsey, chief investment officer at Leuthold, the market has been caught off guard not by how high yields are as bond prices weaken, but how fast they're going up.
“Everyone is focused on a rate level, but the rate-of-change is impacting things at almost a subconscious level,” Ramsey said. “The upward trend in rates is already sufficient to slow or reverse the market's ascent.”
Specifics of the measure are complicated, but basically the model looks at how quickly returns are weakening in corporate credit. Namely, it's the 10-week exponential moving average of the 26-week percentage change in the Dow Jones Corporate Bond Index (which measures price, the reciprocal of yields). The lower it goes, the tighter monetary conditions, and therefore worse for stocks.
Leuthold's gauge last week dipped below zero for the first time since June, triggering a sell signal for shareholders. It's one reason the firm cut equity holdings in its core and global funds to 58 percent from 65 percent.
Getting the bond-equity relationship right is key for stock investors who have been on edge with the Federal Reserve expected to raise interest rates three times this year and the market going longer than ever without a 5 percent pullback. While some have warned of trouble for stocks if 10-year Treasury yields rise above 3 percent, an alternate view of Ramsey's theory is that market might be fine should the ascent in rates slow.
Leuthold studied market performance since 1920 and found that the Dow Bond Oscillator has shown a good track record of predicting equity returns. When it stayed below zero, as in the case now, the Dow Jones Industrial Average fell at an average annualized rate of 0.3 percent. Equity returns were more robust, rising 11 percent, when readings were above zero.
“It's the rate-of-change in bonds, not the bond yield level, that has the stronger impact on the stock market,” Ramsey said.
To contact the reporter on this story: Lu Wang in New York at lwang8@bloomberg.net.
To contact the editors responsible for this story: Arie Shapira at ashapira3@bloomberg.net, Chris Nagi, Richard Richtmyer
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