V.10:10 (403-406): Stocks Yield To Bonds by Tushar S. Chande

V.10:10 (403-406): Stocks Yield To Bonds by Tushar S. Chande
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Stocks Yield To Bonds by Tushar S. Chande

A stock's price may be considered a mechanism to adjust its dividend yield. In the short run, the dollar amount of the dividend is fixed, and so stock prices change to accommodate changes in bond yields. Lags occur because it takes time to convince most participants that bond yields have changed meaningfully. Here's an example of quantitative intermarket analysis, analyzing the relationship of bond yields to stock dividends.

The general relationship between stocks and bonds is widely recognized. Stock dividends and interest rates play an important role in any fundamental analysis of stock valuations. An excellent intuitive explanation of the link between stocks and bonds was provided by John J. Murphy in the June 1992 issue of STOCKS & COMMODITIES, in which he noted that stock and bond prices generally move in the same direction. At important turning points, however, bond prices usually turn ahead of stock prices.

Prices are inversely related to yield because the dollar amount of the interest paid on a bond is fixed. As prices increase, bond yields decrease. In the short run (many months or perhaps a few years), the dollar amount of the stock dividend is fixed because corporate managements typically change their dividend policy only once a year. Hence, price changes are needed to adjust a stock's dividend yield. In the long run, the dividend can be changed (cautiously increased or reluctantly decreased), thereby adjusting relative yield relationships without requiring large price changes.

In effect, the market is trying to maintain a ratio of stock dividends to bond yields that reflects expectations of relative risk. If stocks are perceived as being riskier than bonds, then investors demand a relatively higher stock dividend yield, lowering stock prices. Even if the perception of stock returns remains unchanged, a change in the perception of bond riskiness may increase bond yields. The adjustment of stock yields may occur quickly or slowly and proportionately or disproportionately to changes in bond yields. Since stock traders mostly trade stocks and bond traders mostly trade bonds, the two markets may go their own separate ways when observed on a daily basis. A rough parity is eventually re-established, often with dramatic price changes.

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