Are Bonds Announcing a Stock Market Correction?

This week's see-saw dynamic in U.S. stocks continues this morning, with the S&P 500 and the narrower, price-weighted Dow Jones Industrial Average up 0.65% and 0.55%, respectively, at 10:05 a.m. EDT.

Moving in separate directions
Even before this week's stock market gyrations, which were kicked off by a sharp decline on Monday, many investors and pundits had been loudly calling for a correction. Indeed, the market's rally since last year's June low has been a dogged, low-volatility climb that appeared to break from the "risk-on/risk-off" dynamic that has governed asset markets in the aftermath of the financial crisis, despite the fact that many of the same macroeconomic headwinds remain.

One ominous sign for stocks can be found not in the stock market, but in bonds, with Treasury bonds in particular finding new favor with investors since early March. Bill Gross, who manages PIMCO's Total Return Fund, the world's largest bond fund, has lifted its allocation to U.S. Treasuries to 33% against 28% in February -- the highest it has been since July. The decline in yields suggests that the risk of deflation, or at least a slowdown in the economy, has increased.

As the following graph shows, bonds' new-found popularity shows up in a split between the charts of the 10-year Treasury yield and the S&P 500's level over the past month (as bond prices increase, yields decline):

Note that a drop in yields (blue line) has accompanied the stock market wobbles in mid-2011 and during the second quarter of 2013:

While I'm not convinced that a stock market correction is imminent, I do think this week is a healthy reminder that stock prices do not move only in one direction. Volatility had been remarkably muted over the past several months, and investors need to accept that this is unlikely to be the status quo on an ongoing basis.

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Fool contributor Alex Dumortier, CFA has no position in any stocks mentioned; you can follow him on LinkedIn. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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