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Home Bonds

Stocks vs Bonds. A Portfolio Allocation Strategy

MtR by MtR
June 13, 2021
in Bonds
0
Stocks vs Bonds. A Portfolio Allocation Strategy


Summary

Bonds are purchased for capital gains.

Bonds outperform stocks for periods of up to two years.

The business cycle is the strategic tool to help you decide when to hold them.

There are periods lasting up to two years when bonds outperform the stock market (ETF: SPY). This article explores the timing model showing when bonds’ appreciation outpaces the market (SPY). The focus here is investors buy bonds for capital gains not for income, recognizing total return is an important metric.

Bond prices are driven by four basic factors: duration, risk, liquidity, and interest rates level. The impact of these variables on bond prices is studied in detail in the classic book by M. L. Leibovitz and S. Homer “Inside the yield curve”. The ETF TLT is used here as a proxy for bonds. TLT seeks to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities greater than twenty years.

TLT is the safest bond portfolio because it is invested in US Treasury obligations. TLT holdings have a long maturity and long-maturity bonds have the greatest price change when interest rates change.

Source: St. Louis Fed, The Peter Dag Portfolio Strategy and Management

The above chart shows 10-year Treasury bond yields (blue line) and the growth of GDP after inflation (red line). The chart shows the long-term trend of yields follows closely the growth of real GDP. In other words, economic growth and inflation are the main determinants of the long-term trend of 10-year Treasury bonds.

If investors believe the long-term growth of the economy after inflation is 2.0%, they should also assume yields are likely to trade close to 2.0%. Of course, much is being said about the action of the Fed and the government. Whatever they do, the ultimate impact of their actions is on economic growth after inflation. Despite, or because of, the programs launched in the past two decades, the trend of economic growth has been declining and is now below its long-term average. I discussed in detail the reasons here.

From a portfolio strategy viewpoint, the profit and hedging opportunities arise by using the business cycle framework.

Source: The Peter Dag Portfolio Strategy and Management

The simplest way to look at the business cycle is to examine the decisions made by executives to control inventory levels. It is a way to relate price moves to business decisions rather than exogenous and unexpected events.

Business, following a period of protracted economic weakness (Phase 3 & 4) recognizes it does not have enough inventory to meet demand. The decision to increase inventory levels involves an increase in production (Phase 1). This process requires hiring new workers, boosting the purchase of raw materials (commodities), and raise the level of borrowing to meet current operations and invest to improve capacity.

The outcome of these decisions is to bolster demand as more workers find jobs, and place upward pressure on commodities and interest rates. This is the time the business cycle moves from Phase 1 to Phase 2.

The process reinforces itself until it reaches extreme conditions. Toward the end of Phase 2 inflation becomes a concern while interest rates reach levels discouraging the purchase of big-ticket items and new homes.

The decline in purchasing power forces the consumer to reduce spending. Business at first does not recognize this change. Eventually the rise in inventories has a negative impact on earnings. Business decides to reduce inventories to protect profitability. Workers are laid off, raw material purchases are reduced, borrowing is curtailed to reduce interest costs.

The business cycle is now going through Phase 3 and Phase 4 until wages, inflation, commodities, and interest rates decline enough to stimulate again consumers’ demand.

This is the time Phase 1 starts all over again. Economic strength improves and the markets react to these changing conditions.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

Let’s see now how these actions impact bond yields and their relationship with the stock market. The trend of bond yields reflects closely the business decisions to manage the inventory cycle. The above chart shows the yield on the 10-year Treasury bonds (upper panel) and the business cycle indicator updated in real-time and reviewed in each issue of The Peter Dag Portfolio Strategy and Management. (An exclusive complimentary subscription is available to the readers of this article.)

The chart shows yields rise when the business cycle rises, reflecting the efforts to finance the re-stocking of inventories and improve and increase productive capacity. Yields decline, however, when the business cycle declines, due to the reduction in production and financing needs. The point is bonds tend to appreciate (bond yields decline) when the business cycle declines. Bond prices are likely to decline (bond yields rise) when the business cycle rises.

The relationship is particularly noticeable because nothing has been said about the action of Congress or the Fed to “drive” the markets. The data to compute the business cycle graph come exclusively from real-time market data.

The relationship between bond prices (TLT) and the market (SPY) provides a useful strategic tool. TLT prices move inversely to the trend of yields ($TNX in the above chart).

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The ratio of SPY and TLT is shown in the upper panel. SPY outperforms TLT when the ratio rises. SPY underperforms TLT when the ratio declines. The lower panel shows the business cycle indicator discussed in every issue of The Peter Dag Portfolio Strategy and Management and is updated on a real time basis using market data on www.peterdag.com.

TLT has outperformed SPY for periods of up to two years during a complete business cycle. The relationship shown on the above chart is important for two major reasons. In a period when the economy slows down and the business cycle declines, a portfolio heavily exposed to long-term bonds such as TLT is likely to outperform SPY.

The second major advantage in overweighing bonds during a decline in the business cycle is its hedging features. For instance, during the business cycle decline of 2018-2020 a portfolio overweighted in TLT offered great strategic advantages due to the market collapse because of the economic slowdown started in 2018 and culminating with the crash of March 2020 due to the pandemic. This event signaled the bottom of the business cycle (see above chart).

Since March 2020, as the business cycle kept rising, SPY has outperformed TLT in line with previous patterns. A decline of the business cycle will cause TLT to outperform SPY as it did in 2018-2020, 2014-2015, and 2011-2012.

Key takeaways

  1. Bond prices rise and yields decline when the business cycle declines (Phases 3 & 4 of the business cycle).
  2. Bond prices decline and bond yields rise when the business cycle rises (Phases 1 & 2 of the business cycle).
  3. Bonds outperform stocks for their capital appreciation and are attractive for their hedging features when the business cycle declines.
  4. Stocks outperform bonds when the business cycle rises, signaling a stronger economy.

For a look at all of today’s economic events, check out our economic calendar.



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