Dow Vs Bond Yield

Dow continued its uptrend by closing positive (+20 points) on Monday. Volume declined further to 4.1 billions. It is wave 5 unless Dow starts to jump with high volume. Investor's mood can change very fast, all you need is Dow to put on 300 to 400 points for 2 days with volumes of 7 to 8 billions. It appears unlikely at this moment.

The relationship between stock market movement and bond yield has been widely studied. Investors usually buy stocks in anticipation of good economy and buy bonds to lock in a fixed interest return in anticipation of poor economy. Bond yield has an inverse relationship with bond. When bond price moves up due to heavy buying when investors decided to switch from stocks to bonds, its yield will drop correspondingly. Similarly when investors decided to switch from bonds to stocks, stock prices go up, bond prices come down and bond yields move up. It simply means stocks and bond yields generally moved in the same direction. However, stocks and bond yields can move in an opposite directions as shown below.

During second half of 2006, due to excess liquidity, investors moved into both stocks and bonds, it caused a divergence between Dow and bond yield. 4 months before the October 2007 market peak, divergence appeared, bond yield started to move lower 3 months ahead of Dow. In January 2009, again the bond yield started to move up 3 months ahead of Dow, another divergence. The latest divergence started in early August when bond yield started to move lower whereas Dow continued to move upwards until yesterday. Unless the bond yields can reverse from downtrend to uptrend pretty soon, it will ultimately pull the Dow southward. The question is when.