Fear Feeding Greed With S&P 500 Correlation to Bonds (Update1)

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By Whitney Kisling and Elizabeth Stanton

June 28 (Bloomberg) -- U.S. stock prices are mirroring government bond yields more than ever, a signal to bulls that shares may be poised to rally.

The Standard & Poor’s 500 Index and 10-year Treasury rates posted a correlation coefficient of 0.8412 in the 60 trading days through June 16, showing stock prices and bond yields were the most linked in Bloomberg data going back to 1962. The last time the relationship was almost this strong during an economic expansion was at the beginning of the 2002 to 2007 bull market, when the benchmark gauge for U.S. equities doubled.

Rising correlations show investors are ignoring relative values among industries and assets and reacting to day-to-day signals on the economy, convinced Europe’s debt crisis will spur the second global contraction in three years. Invesco Ltd., Wells Capital Management Inc. and Chemung Canal Trust Co., who together manage $957 billion, say those concerns are overblown and shares will advance as the fastest profit growth since the mid-1990s restores confidence.

“When you add up the fundamentals, they’re there,” said Fritz Meyer, a Denver-based senior market strategist at Invesco, which oversees $580 billion. “The problem is this emotional aspect,” he said. “The historical truth in the stock market is you want to buy stocks when there’s skepticism and fear all over the place and sell when everyone’s feeling complacent.”

Deflation Threat

September futures on the S&P 500 rose 0.3 percent to 1,078.40 as of 10:09 a.m. in London.

The gauge lost 3.7 percent to 1,076.76 last week after new- home sales sank to a record low and the Federal Reserve signaled that European indebtedness may lead to a weaker U.S. economy. Deflation, or a general decline in prices, is possible within the next few years, Nobel Prize-winning economist Paul Krugman said at a June 22 conference in Tel Aviv.

When the S&P 500 dropped 3.9 percent on May 20 following higher-than-forecast U.S. jobless claims, yields on 10-year Treasuries plunged 0.156 percentage point. The stock index slid 3.4 percent and the rate on notes fell 0.162 point on June 4, after employment growth trailed economists’ estimates.

Equities are also moving in lockstep with each other and assets tied to economic growth. The correlation coefficient between the S&P 500 and the Thomson Reuters/Jefferies CRB Index of 19 raw materials has been above 0.5 since April 13 and climbed to 0.77 on May 14, the highest since at least 1956, data compiled by Bloomberg using 30 days of trading show. Almost 80 percent of swings in stocks within the S&P 500 are related to movements in the broader market, according to London-based Barclays Plc.

Correlation Study

“Correlation is one of the great lessons of the whole crisis, and it hasn’t let its grip on the markets go,” said Barry Knapp, the New York-based head of U.S. equity strategy for Barclays. Knapp estimates the S&P 500 will climb 13 percent to end the year at 1,210. “Whatever the nature of the crisis, the one decision investors seem to make is whether they should be in risky assets or out.”

Linkages among markets are so high because investors are worried about a repeat of the 2008 credit crisis, which sent U.S. equities, commodities and real estate prices to their worst losses in half a century, Knapp said. The correlation level between the U.S. equity benchmark and 10-year Treasury yields averaged 0.5711 from October 2007 through March 2009, when the S&P 500 plunged 57 percent.

Home Sales

Reports on sales of new and previously owned homes last week showed that purchases reversed course in May after getting a bump higher from government stimulus programs including a buyer tax credit. About half of 106 U.S. forecasters in a study from Madison, New Jersey-based MacroMarkets LLC expect price declines in 2010 and half anticipate either little-changed or increasing values.

Congressional negotiators approved the most sweeping overhaul of U.S. financial regulation since the Great Depression on June 25. Financial companies in the S&P 500 rose 2.8 percent after the bill was announced as analysts said it won’t fundamentally reshape Wall Street’s biggest firms. The S&P 500 has lost 5.4 percent since President Barack Obama proposed banning proprietary trading by banks on Jan. 21.

“Investors are very worried about which direction the global economy is going to take,” said Bart Zeldenrust, senior fund manager at Rotterdam-based Robeco Group, which oversees about $167 billion. “Correlation was very high during the financial crisis because there was only one bet that you could make in your portfolio: risk is on or risk is off. And it’s still very much so. It’s not a good sign.”

Diversification Failure

The lockstep moves are hurting strategies designed to smooth out fluctuations across equities, industries and assets. Standard deviation, a measure of the variation in returns, for mutual funds investing in the biggest U.S. companies that have an average value similar to the S&P 500 fell to 5.8 percent in the first quarter, based on data compiled by Lipper & Co. and Bloomberg. That’s the lowest level in three years.

“It’s been impossible for stock pickers lately,” Savita Subramanian, quantitative strategist at Bank of America Corp. in New York. “It’s been less about stock selection, less about fundamentals or company management, and it’s been all about macro.”

U.S. equity markets have lost $1.78 trillion since April 23 on concern the European debt crisis will spread. Ryan Caldwell, whose $20.7 billion Ivy Asset Strategy Fund has beaten 98 percent of its rivals in the past five years, said the S&P 500 will rebound from May’s 8.2 percent loss should concerns about deficits in Greece, Portugal and Spain subside.

Picking Stocks

“No matter what you’re doing on the stock-picking portion of the portfolio now, it’s clearly being trumped by the macro environment,” said Caldwell, a fund manager for Overland Park, Kansas-based Waddell & Reed Financial Inc. “If you see the macro worries recede, I think you’ll see a pretty quick recovery in asset prices.”

Periods of risk aversion, when investors sell volatile assets and buy securities perceived as havens, have lasted an average of two months in the past, according to data since the 1930s compiled by Deutsche Bank AG. That suggests stocks will start rebounding in mid-July, says Binky Chadha, the firm’s New York-based chief U.S. equity strategist, who predicts the S&P 500 will rise 28 percent to end the year at 1,375.

Expanding Economy

The last time movements between Treasury yields and stocks were this similar during an economic expansion was in October 2002. The S&P 500 jumped 34 percent in the next 12 months and another 51 percent through October 2007 as corporate earnings recovered from the bursting of the technology bubble. U.S. gross domestic product grew at a 2 percent annual rate in the quarter that ended Sept. 30, 2002, compared with 2.7 percent in the first three months of this year.

“The market is worried about deflation and depression,” said James Paulsen, who helps oversee about $375 billion as chief investment strategist at Wells Capital Management in Minneapolis. “For this correlation to go away, you’re going to have to first have confidence the recovery is sustainable, which means stocks go up.”

Economists predict a 3.2 percent expansion in U.S. GDP this year, the biggest since 2004, according to estimates compiled by Bloomberg. Earnings for S&P 500 companies may rise 32 percent in 2010 and 17 percent in 2011, the largest two-year advance since the period ended in 1995. The index is trading for 13.2 times forecasted 2010 earnings, compared with an average multiple of about 16.4 since 1954 using reported profit, the data show.

May Losses

McDonald’s Corp. may rally once investors’ focus returns to earnings and valuation, said Tom Wirth, senior investment officer for Chemung Canal, which manages $1.6 billion in Elmira, New York. Shares of the world’s largest restaurant operator fell 5.3 percent in May as the S&P 500 dropped 8.2 percent. The Oak Brook, Illinois-based company beat estimates for the quarter ended March 31 and said this month that May global sales rose more than analysts projected. Its dividend yield is 3.26 percent, compared with 3.11 percent for the 10-year Treasury.

“When fear enters the market, then you sell first and ask questions later,” Wirth said. “Investing is for the long term, so if you can buy high-quality stocks at these prices, you do it. If they’re high-quality companies, they’ll come back.”

To contact the reporters on this story: Whitney Kisling in New York at wkisling@bloomberg.net; Elizabeth Stanton in New York at estanton@bloomberg.net.