Time Frame: Medium-Term | Update Schedule: Daily | Source: SentimenTrader
Construction:
Asset allocators face what on its surface is a relatively simple question?should we invest in stocks or bonds? Certainly other asset classes come into play, but for the most part the bulk of assets shift between those two.
As stocks become a bigger part of investment portfolios, allocators tend to sell them and put the money into bonds, and vice-versa. There are any number of ways to monitor the relationship between the two, but the best we have found is a simple ratio between the S&P 500 and the yield on 10-year Treasury Notes.
This indicator measures the ratio between these two indexes, then transforms it into an expression which shows how extreme it is compared to other recent readings. What we're looking for are the real extremes - when stocks become "overvalued" relative to bonds, then we often see stocks decline and bonds rise. When stocks become "undervalued" according to the ratio, then stocks typically rise while bonds fall (i.e. yields rise).
Our stock/bond ratio will rarely get above +3 or below -3. Basically, a reading of +3 means that stocks are so overvalued that we see a more extreme reading only about 1% of the time - very unusual. When the ratio hits -3, it suggests that stocks are deeply undervalued relative to bonds, and we rarely see a more extreme condition.
As noted above, when the ratio becomes very high, then we should expect stocks to fall and/or bonds to rise. When the ratio is very low, then we look for stocks to rally and/or bonds to fall in value.
