Why Stocks Could Thrive Despite a Gloomy Bond Market

Who do you believe when stocks and bonds disagree?

The old adage is that the bond market is the "smart money." So if you see a stock crashing, but the bonds are doing fine, the scare might not be as bad as most folks expect.

That's usually the setup when these two markets disagree. But every once in a while, you get the opposite situation... when bonds say "danger ahead" while stocks are doing fine.

That's where we are right now...

The bond market is betting on a recession. Based on one measure, it's more bearish than it was before the 2008 financial crisis. And it's even approaching levels from 1978... just before America was hit with a bout of "stagflation." (That's a period of both low growth and inflating prices. It's a "worst of both worlds" kind of economy.)

Nonetheless, stock investors keep buying.

When signals conflict this much, it's hard to know which way to invest. But there are a few compelling reasons why stocks may have more room to run.

Let me explain...

The bond market isn't buying this stock rally. We can see it by looking at the yield spread between the 10- and two-year Treasury bonds.

When the spread is negative, it means trouble for the economy. Today, as I mentioned above, the spread is wider than it was before the 2008 bust, and nearing levels we saw in the 1970s.

That's a major warning sign for investors. But the bond market might be wrong this time around.

The reason is simple... Stocks just keep moving higher.

Last Thursday, the Nasdaq Composite Index enjoyed its best day in more than a month. And the S&P 500 Index and the Dow Jones Industrial Average both had their biggest one-day gain since January.

It was a massive rally for stocks. And history shows it could be significant. We decided to dive into the data to see what such a big move could mean going forward...

The S&P 500 popped 1.95% on Thursday, for its biggest jump in 111 days. So I measured historic jumps of 1.95% or more, after the same interval or longer.

It turns out, Thursday's jump was pretty rare. Since 1990, there have only been 24 similar moves. And on the whole, they pointed toward outperformance in the year ahead. Take a look...

The S&P 500 returned about 8% annually over the past 30-plus years. But after a pop like Thursday's, stocks tended to outperform...

They came out a percentage point ahead in the six-month period... and two points ahead over the next year. Plus, stocks were higher a year later 87% of the time. That means the "pop" signal is a fairly accurate indicator of a sustained uptrend in stocks.

We're also seeing more bullish activity under the surface to support it...

More than half of S&P 500 companies have reported earnings for the latest quarter – and 80% of those beat expectations. So, despite all the fear in the economy today, businesses are showing resilience.

That's not what the bond market sees. But fighting the trend is rarely the right move. And with stocks consistently moving higher, the bond market might have it wrong this time.

Good investing,

Sean Michael Cummings

Further Reading

"The market has a habit of doing the opposite of what most folks expect," Brett Eversole writes. One group of traders is extremely bearish today. They're betting against the market en masse. But when everyone is bracing for a crash, history shows it means more gains are likely... Read more here.

Right now, trillions of dollars are sitting in money-market funds. That's a major sign of fear. But this kind of bearish sentiment is exactly what you should look for – because when all that cash floods back into stocks, it will lead to a powerful boom... Learn more here.