Schaeffer's Trading Floor Blog

Bullish Signs from the Bond Yield Spread

A narrowing yield spread could mean stocks have reached a short-term bottom

by 6/12/2012 12:56 PM
Stocks quoted in this article:

One indicator that has been flashing a "buy equities" signal over the past week is the [Stock Bond] Yield Spread. This is defined as the difference between the yield on the highest-grade corporate bonds and the yield on Dow Jones Industrial stocks.

Below is a intermediate-term chart of the data for illustration. As the black line illustrates, the stock/bond yield gap spread is at the lowest (least wide) level since last summer's equity trough. A narrow spread as defined by the above calculation has been consistent with short-term equity troughs over the past few years. (For comparison's sake, the red line in the chart below is the S&P 500 Index (SPX)).


Contrarily, an increasing (widening) spread between the two yields has been consistent with equities running out of steam and eventually rolling over or pulling back to support.

I see the reason for the recent decrease in the spread as two-fold: first, you have high-grade corporate yields, which are declining due to investor interest (the price moves up, the yield goes down). Secondly, as the DJIA stagnates (resulting in a flattening yield), the yield has increased as a percentage of index value.

The Federal Reserve maintains a low interest-rate environment to support the economy and force market participants to take on more risk. When compared to corporate bonds, the yield on the Dow Jones Industrial Average sure looks compelling at this time.

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