From time to time in these articles I've commented on the reaction of the bond and stock markets to the day's economic news. The bond market is highly sensitive to trends in the economy. A rapidly growing economy creates greater demand for capital causing interest rates to rise and bond prices to fall. Conversely, slowing economic growth, such as we are presently experiencing, slows capital demands causing interest rates to fall and bond prices to rise.

All other things being equal, slow economic growth would be accompanied by slowing corporate profits which should translate into lower stock prices. So, it would seem that falling interest rates should lead to falling stock prices. Historically, this has not been the case. The record shows that falling interest rates have generally led to higher stock prices and vice-versa. Moves in the stock market are highly anticipatory. In fact, the Standard and Poors 500 stock index is one of the most reliable components of the Commerce Department's Index of Leading Economic Indicators. Stock market participants appear to perceive falling interest rates as an opportunity for corporations to borrow cheaply to finance their expansions and for individuals to borrow cheaply to purchase goods and services. What's more, as interest rates on bonds, CD's, and money market funds decrease, the yields available from stocks become more attractive.

The relationship between changes in interest rates and subsequent changes in stock prices has been studied by Nelson Freeburg the editor of Formula Research. In an article, appearing in the February 1995 issue of Stocks & Commodities magazine, Freeburg analyzed 30-year T-bond and S+P 500 stock index data from 1957 to 1994. For each week of this 38-year period Freeburg calculated the percentage change in the bond yield over the preceding six months and compared it with the percentage change in the S+P over the coming six months.

Freeburg found that future six-month changes in the S+P are significantly related to past six-month changes in T-bond yields. The results are too extensive to report in full detail; but, I will summarize them. For six-month past percentage changes in yield running from zero to -14.3%, the mean annualized future return on the S+P ran from 10% to 18%. Over this range of yields, 78% of all the future six-month S+P changes were positive. For yield changes between zero and approximately +5%, the mean annualized return was about 5%, and 63% of the S+P changes were positive. Finally, for yield changes from +5% to +17.5%, the mean annualized return was a little less than -1% and only 42% of the S+P changes were positive.

In the article, Freeburg describes an investment decision model based on the results of his research. The model assumes that the S+P 500 Index is bought when the 6-month percentage change in the 30-year T-bond yield drops below -4% and is sold whenever the 6-month percentage change in the 30-year T-bond rises above +14%. The model assumes that dividends are reinvested and that funds are invested in commercial paper during periods when the model is not invested in the S+P 500.

For the 38-year study period, nine out of nine buy signals were profitable. The compounded annual return was 13.3% compared with 10.2% for buy and hold. The model was invested in the S+P 500 for 74% of the period. Results between 1980 and 1994 were considerably better. The compounded annual return was 18.4% versus 14.7% for buy and hold, and the model was invested in the S+P 500 72% of the time.

There were only nine investment periods over the entire 38 years. So, this is obviously a long-term approach. For example, the most recent buy during the study period was just after the crash in 1987. The subsequent sell signal was not until approximately six years later in early 1994 when the Fed began to raise interest rates.

To bring the data up to date, I crunched the weekly closing T-bond numbers from January 1993 to last Friday, January 5, 1996. This revealed a buy signal on 3-24-95 at an S+P 500 Index value of 500.97. This signal was still in effect last Friday with the S+P 500 at 616.71 -- a gain of 23.1% in 42 weeks, or an annualized gain of 28.6%.

Summing up: Economic conditions, real or perceived, drive the bond markets, and changes in the yield of the 30-year T-bond provide an indicator of future stock price changes that has proven to be reliable for the past 39 years.

Byline: Lafferty (MF Merlin)