Signals From the Stock/Bond Ratio

All markets experience primary uptrends and downtrends, averaging from nine months to two years. However, not everyone knows that relationships between markets also undergo price movements that last for similar time spans.

Here are three key ratios to watch:

The ratio between stocks and commodities.
The ratio between commodities and bonds.
The ratio between stocks and bonds.

I follow these inter-asset relationships for three reasons. First, changes in their direction often reliably signal the current position of the business cycle. The cycle is nothing less than a set series of chronological sequences, of which turning points in financial markets are a key part. If commodities peak against bonds, for instance, it tells us that the cycle has reached a deflationary phase.

A second reason for following these relationships is that they can tell us which asset class is likely to experience superior performance. Thus, if stocks peak against commodities, it means that we should be emphasizing inflation-sensitive assets, such as the iPath Dow Jones AIG Commodity Index ETN (DJP - commentary - Cramer's Take) and so forth.

Finally, these relationships are an invaluable tool in deciding which sectors to invest in. Deflationary signals imply investments in liquidity-driven or early cycle leaders, such as utilities, financials and consumer staples. On the other hand, inflationary signals would suggest basic-industry and resource-based equities.

Right now, I'm closely monitoring the stock-to-bond ratio. You can calculate this in several ways, but perhaps the easiest formula to follow is this: Divide the S&P Composite by the iShare Lehman 20+-Year Treasury (TLT - commentary - Cramer's Take). (The TLT is an exchange-traded fund that reflects bond prices with a 20-year maturity.)

The two charts below show the ratio's history, going back to the middle of the 19th century. (Before the listing of the TLT and the S&P Composite, I used other government bond and equity series.)

Click here for larger image.

Source: Pring.com

Click here for larger image.

Source: Pring.com

The green highlights show when the smoothed momentum, or KST, is in a rising mode, and the red highlights when it is falling. The KST is a smoothed long-term momentum series that reflects primary bull and bear markets in the relationship.

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At the time of publication, Pring had no positions in any of the stocks mentioned in this column, although holdings can change at any time.

Martin J. Pring is president of pring.com, and is actively involved in Pring Turner Capital Group, a money management firm. He also publishes the monthly market letter "Intermarket Review." Pring is the author of several books, including Technical Analysis Explained, and numerous educational, interactive CDs. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Pring appreciates your feedback; click here to send him an email.

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