Smart Markets, Foolish Choices

The Results

The monthly returns on the two corporate bond series and on the S&P 500 were analyzed from the beginning of 1928. A simple visual inspection of the series on a coincident basis didn't hold out a lot of promise for a strong statistical relationship. That a stronger relationship between lower-quality bonds and stocks existed compared with the one involving higher-quality issues should surprise no one.

Coincident Monthly Returns, 1928-2003

Source: CRB Infotech

When the data were examined for Granger causation, the results were similarly inconclusive. None of the cross-correlations were as strong as the autoregressive (the series itself) correlations.

We can't say that corporate bond returns cause stock returns or vice versa. All we can say is that the stock market does a better job of forecasting the corporate bond market -- R-squares of 1.2% and 4.7% for the AAA and Baa, respectively -- than either bond market does for stocks, 0.4% and 2.7% for the AAA and Baa, respectively.

The final tidbit is that the S&P 500's autoregressive R-squared of 7.9% is higher than that of either bond market.

Forecasting Advantage Stocks get the edge?
Autoregressive
	S&P 500	AAA	Baa
	7.9%	2.4%	7.0%
Cross
		Dependent
Independent	S&P 500	AAA	Baa
S&P 500		1.2%	4.7%
AAA	0.4%
Baa	2.7%
Source: Federal Reserve, CRB Infotech, TSC research

On the basis of these data, we have to grant stocks an advantage over corporate bonds as the smarter market. Not a win, but an advantage, one derived from a single test over a very long sample and at a monthly frequency. But there's no crying in baseball, and no ties, either. Stocks get the win by default in this, the first game of the World Series. I'll be back shortly with other tests.

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