After the last week of stocks taking a beating, it is safe to say that risk is back off. The S&P 500 has declined by 67 points or 4.7% once the market moved past the Presidential election and was able to place all of its focus on the impending Fiscal Cliff. With this move, the S&P 500 is now well past its intermediate trend-line, suggesting the recent run by the bulls is over for now.
So how low can stocks go? If the bond market has anything to say about it and based on the action in the 10-Year U.S. Treasury, stocks can drop a lot more.
Typically stock prices and bond yields move in tandem like two people dancing hand in hand and in lockstep. When the economy is growing, stocks rise due to increasing expectations of better future profits.
Along the same lines, higher growth expectations may at some point stoke the inflation flames. Rising prices of everyday items mean less purchasing power if you assume income growth fails to keep pace. Rising inflation expectations usually results in higher bond yields. This occurs because bond buyers want higher yields in order to be compensated for the rising prices of items they can buy in the future. As holders of fixed income securities, the value of their bond investments falls as prevailing market yields are higher.
Conversely, when inflation is flat or declining (via disinflation or deflation), yields decrease which in turn lead to an appreciation in bond prices. In addition, yields may fall in a flight to quality bid as market participants seek safe-haven assets in fear of some type of shock that is disruptive for both the economy and stocks. (For more information on the relationship between interest rates and stock prices, check out this post from Learnbonds.com)
This relationship for the most part holds true over time. Intuitively, investors are well aware of this relationship as long-term investing usually includes some form of asset allocation between the two distinct but related asset classes. To quantify this, the correlation between the change in yield on the U.S. Treasury 10-Year and the percentage change in the S&P 500 is around 60 to 65% over the past several years. As a source of context, zero means no correlation while 100% means they move perfectly in lockstep. So there is a high degree of correlation between the two assets based off of the last few years of data.
However, since the onset of summer bond yields and stock prices started to diverge. The yield on the 10-Year closed out May at 1.56% while its equity counterpart finished the month at 1310.33. Soon after, the 10-Year sank lower to 1.46% by the end of July on fears of an economic slowdown.
Given these fears, one would expect stocks to be negatively affected. Yet equity prices continued to move higher as the S&P 500 closed at 1379.32 at the conclusion of July.
Even with the recent slide, the performance between the two remains pretty far apart. The 10-Year is currently trading at 1.59% which is basically the same level as at the end of May. The S&P 500 on the other hand is still lofty by comparison and closed out the day at 1355.49.
If the two were to join hands once again where the correlations begin to re-establish themselves, we could see the S&P 500 trading back closer to its May level of around 1300. Of course that assumes a stable 10-Year Treasury.
Given the severity of the Fiscal Cliff which could push the U.S. economy back into a recession, it would be reasonable to expect even more demand for safe-haven assets and even lower Treasury yields than where they are now. This in turn could push stock prices even lower as risk assets fall completely out of favor.
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