The Most Important Indicator Ever: The Equity to Bond Ratio

• Posted by Greg Harmon
• on October 4th, 2013

This ratio, the measure of the Equity market to the Bond market may be the most important indicator to follow as an investor or trader. Over 70% of the optimal investment performance is found by selecting the proper asset allocation. Putting cash aside, that leaves how you should allocate you money between stocks and bonds. I am an equity manager/trader so I take control mostly after the decision is made, but still find it important to understand how this ratio is forecasting the market, by showing flows one asset class to the other. Take a look at the chart below since the equity market peak in October 2007 (purple line on the left).

This chart looks at the S&P 500 SPDR, $SPY against the US Treasury Bond ETF, $TLT, as a proxy. There is a lot going on but lets focus on just a few items. First, since that peak, Bonds have out performed Equities over the entire period. That gap is narrowing now as noted by the blue line approaching the orange line. The gap has not been this narrow over this time period. With the Bond measure falling and the Equity measure rising this looks to continue.

The second item is that the ratio itself (the bottom line) is also rising. In fact it is consolidating after making a new higher high and above the 50 week Simple Moving Average (SMA). This consolidation is happening at one of the stall points on the way down from the 2007 high levels and a 78.6% retracement from the top to the bottom, an important Fibonacci level. With the trend higher a full retracement is expected on a move over the mid September high.

Finally, consider what this means for both Equities and Bonds. This ratio has shown a flow of cash from Bonds into Equities. quantitative measures have shown that the flow has been minimal compare to the flow in the opposite direction so it could have a long way to go. After big recent moves some pause or pullback may be in order, but as anything other than a short term trader, do you really want to own Bonds and not Stocks?

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