The conundrum of stock versus bond prices

TL;DR

This paper explores the dynamic relationship between stock and bond prices during market crashes and rebounds, using exogenous shocks to understand investor behavior and distinguish genuine rallies from spurious ones.

Contribution

It introduces a quasi-experimental approach to analyze market responses to shocks and proposes criteria to identify the end of rebounds and differentiate rally types.

Findings

Bond and stock prices are strongly connected during crashes and rebounds.

Market correlations fade as rebounds end, indicating loss of investor coherence.

A framework to distinguish genuine market rallies from artificial ones.

Abstract

In a general way, stock and bond prices do not display any significant correlation. Yet, if we concentrate our attention on specific episodes marked by a crash followed by a rebound, then we observe that stock prices have a strong connection with interest rates on the one hand, and with bond yield spreads on the other hand. That second relationship is particularly stable in the course of time having been observed for over 140 years. Throughout the paper we use a quasi-experimental approach. By observing how markets respond to well-defined exogenous shocks (such as the shock of September 11, 2001) we are able to determine how investors organize their ``flight to safety'': which safe haven they select, how long their collective panic lasts, and so on. As rebounds come to an end the correlation of stock and bond prices fades away, a clear sign that the collective behavior of investors loses some of its coherence; this observation can be used as an objective criterion for assessing the end of a market rebound. Based on the behavior of investors, we introduce a distinction between ``genuine stock market rallies'', as opposed to spurious rallies such as those brought about by the buyback programs implemented by large companies. The paper ends with a discussion of testable predictions.