Tuesday, December 13, 2011

Comparative Yields as Timing Prompts

Timing the market to miss large falls but benefit from long bull markets is an investors dream, but moving average studies (eg by Doug Short) and of medium to long term returns of active managers show it is not easy to beat the market.

Recent significacnt changes in bond yields relative to earnings yields on shares on the one hand and between 3 month and 10 year bonds on the other hand have been significant and we may have just had a major prompt to watch for buy signals. In fact we have had two potential bottoms already, 8 August and 26 September, although the fear of recession induced by austerity in most major economies and European disruption could cause new lows. Volatiity induced whipsawing from following timing buy and sell signals is a real risk at present, however for those who have been out of the market until now it could still be a time to take on some risk.

Comparative yields between stocks and bonds and also between long and short dated government securities can be useful prompts, particularly where large changes take place relatively quickly. It is often said that the inversion of the yield curve has predicted 10 of the last 5 recessions, but rapid significant change is a useful prompt to be looked at with employment growth changes and the indicia of market tops and bottoms discussed in recent posts. I have previously done work on these issues based on Robert Shillers research of ├índ data for US markets and published on Seeking Alpha  I have now found data by Colin Nicholson which has enabled me to do a similar exercise for the Australian markets. The emphasis in each chart is on both the relativity and the significant changes in that relativity.

The two charts show comparative yields and rates of change in the ratios between the two yields being compared.

The first chart deals with 3 month and 10 year government bonds. The annotations to the chart tell the story, although I should emphasis that the change in direction from around or above 1.2 or from around or below 0.8 is really the start of the prompt. I understand from my reading that the futures markets are pricing in further rate cuts next year which if they come to fruition will likely bring the both the pink and blue lines above 1.2.



The second chart deals with the relativity between 10 year bond yields and the earnings (not dividend) yield of shares and with significant sharp changes in that relativity. Again, the annotations to the chart tell the story. Other than the depths of the GFC the ratio of bond yields to earnings yields have not been this high since before 1974. Only 1974, 1987 and 2008 have had such a dramatic relative increase in share yields over long bond yields. This is a reflection of extreme fear of recession, unemployment, falling earnings and/or stock market crash. Remember the dictum to "be greedy when others are fearful and fearful when others are greedy'? Well these relativities show others are fearful right now!


10 year bond yields in Australia are at around 4% and have not been at such low levels for a very long time, other than during the GFC. This could be a very bad time to buy bonds or we could be going Japanese. My suggestion is buy on your favourite timing buy signals but be prepared to be whipsawn because you may well get a sell signal within a few months given the situation in Europe and continuing austerity in many countries.



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