Why Treasuries Point to Gains in the Stock Market

Root canal. Tax audit. Coma. For most people, they’re just a few things that sound more exciting than studying the treasury market
 
I’ll admit, treasuries aren’t the most exciting investment out there. That’s why they’re typically relegated to people like me — professional investing nerds — most retail investors don’t go talking about the latest t-bond series they bought; stocks are more interesting, easier to relate to, and they historically generate much bigger gains than treasuries.
 
But treasuries can give investors major hints about where the stock market is going. That’s why every stock investor needs to pay attention to treasuries from time to time. Let me show you how…
 
Let’s start at the beginning. The term “treasury” is a catch-all word to describe debt issued by the U.S. government — when Uncle Sam needs to borrow money, he issues treasuries. Because lending money to the U.S. is essentially considered risk-free, treasuries don’t pay a whole lot. In fact, treasuries have lately offered up investors negative real yields thanks to the impact of inflation; so why would anyone want to buy them? We’ll get to that…
 
As an investor, it’s critical to remember that anything you invest in doesn’t live in a bubble. You probably already realize that your investment in a single stock can be impacted by what’s going on in the market on any given day. Well, the stock market can be impacted by what’s going on in other markets on any given day.
 
The reasoning is simple — the thing that all the major asset classes (bonds, stocks, and commodities) have in common is who their market participants are. In other words, if I’m a sophisticated investor, I have the option of investing in a combination of stocks, bonds, and commodities. Because all of the money is coming from the same place (my brokerage account), the markets are interrelated. There are a few other reasons why markets are interrelated, but for our purposes today, the flow of funds from stocks to bonds (and vice versa) is the most important one.
 
So, back to why the heck anyone would want to buy treasuries to earn a negative return
 
People buy treasuries because they’re a safe place to park cash. That means that when people buy treasuries at current rates, they’re willing to essentially pay for the privilege of staying away from “scarier” assets like stocks and commodities. It’s a move that reeks of desperation…
 
But it’s one that tells us a lot about the stock market. After all, if people are so desperate to get away from stocks that they’re willing to effectively pay the government to hold their money, you know that investor anxiety is a real problem. And for most of 2012, it has been.
 
Treasury prices have been sitting at historic highs for months now, without any real signs of backing down. We know that’s a bad thing, right? After all, if treasuries are high then that tells us that people are still extremely anxious about stocks, and money is still being withheld from the rally that Mr. Market’s been enjoying for most of 2012. That’s not the type of behavior we’d expect to see during a rally. Worse yet, extreme investor anxiety levels mean that stocks could get knocked lower much more easily than if there was more buyer participation taking place in stocks.
 
But something changed in the last week or so. The chart below shows the relationship between the S&P 500 and 10-year treasury notes:
 
 
That recent pullback in the orange line means that treasuries are finally getting sold off in favor of stocks — a very good sign. It’s only the first step though — there’s still a lot of money in treasuries right now. The flip side to that coin is that there’s a lot of money that could move into stocks and help support this rally. Expect more selling in treasuries to make current treasury owners question whether they should be switching that money to stocks right now…
 
Yes, treasuries are too boring for most investors. And obviously, treasuries aren’t a very good place to park your money when stocks are rallying. But, as I’ve just shown you, watching the treasury market can give you a significant leg up on what’s going on in the stock market.
 
I’d recommend occasionally checking on how treasury prices are moving compared to stock prices. You can see both charts together by clicking here.