Why the Bond Market Is Flashing a Buy Signal for Stocks

Strong buy signals for stocks are coming out of the bond market right now, according to Jim Paulsen, chief investment strategist at The Leuthold Group. “When you take the bond market’s message as a whole, I think it’s about as optimistic as the big recoveries we’ve had in stocks and commodities so far,” he told CNBC. The positive indicators that he sees are summarized below.

4 Reasons the Bond Market May Be Sending Buy Signals for Stocks

“When you take the bond market’s message as a whole, I think it’s about as optimistic as the big recoveries we’ve had in stocks and commodities so far,” Paulsen said. The tightening of yield spreads on corporate bonds indicates to him that credit risk is declining, contrary to widespread concerns about dangerously high corporate debt burdens. He also notes that mortgage market spreads also have tightened, pointing to reduced credit risk in that market as well.

He notes that P/E ratios in the stock market have recovered to their levels in early Dec. 2018, before the big selloff. Stated differently, this means that earnings yields have fallen, since they are the inverse of P/E ratios. Meanwhile, the 10-Year T-Note yield is down from 3.2% on Nov. 8, 2018 to 2.6% on March 11, 2019.

“What we’re seeing [is]…an upward valuation of both stock prices and bond prices, reflecting the fact that the economy has slowed, inflation pressure has lessened, and accommodation by policy officials is back and that deserves a higher valuation, which is what we’re getting in both markets,” Paulsen observed. “There’s been a lot of money waiting on the sidelines,” he told Bloomberg.

The contrary view is that sliding bond yields normally reflect growing pessimism about the economy, as The Wall Street Journal reports. According to this school of thought, the stock market rally is bound to sputter once equity investors’ outlook converges with that of bond investors. Indeed, the Fed’s turn to dovishness is taken by various bond investors that the odds of a recession are rising, per MarketWatch.

The latest figures for retail sales show that the decline in Dec. 2018 was worse than originally estimated, 1.6% versus 1.2%, while the rebound in Jan. 2019 was a modest 0.2%, Reuters reports. The January decline in motor vehicle sales was the worst in five years, offset by gains in building materials and consumer discretionary. The December sales drop, meanwhile, was the worst since Sept. 2009, when the economy was coming out of recession.

Paulsen believes that many equity portfolios are underweighted towards cyclical stocks right now. He anticipates that the dollar will decline this year, which should boost commodities prices, and thus benefit energy and materials stocks. He also prefers small caps to large caps, given that small caps historically outperform when inflation is rising.