Stock-bond correlation and the bond quality ratio: Removing the discount factor to generate a “deflated” stock index

Andrea Terzi and Giovanni Verga

No ief0067, DISCE - Quaderni dell'Istituto di Economia e Finanza from Università Cattolica del Sacro Cuore, Dipartimenti e Istituti di Scienze Economiche (DISCE)

Abstract: This paper investigates the cyclical co-movements between US stocks and interest rates by testing a simple model where divergence between stock and bond price behavior is explained by “stock market strength,” where the latter depends on the market climate about future corporate profits—as captured by the corporate bond quality ratio—and an unexplained stock market sentiment. Using two different regression techniques to check for robustness, we find evidence of a statistically significant cyclical correlation between stocks and bonds. On the basis of this finding, we then present a methodology to “deflate” a stock price index such that we can compare stock market strength over time. This is obtained by removing the effect of a changing discount rate—as measured by our regressions—on stock prices. For example, viewed in this light, the past five years in the US stock market reveal a wider fluctuation in stock market strength than we can observe on the basis of stock price indices alone.

Keywords: Stock-bond correlation; Market sentiment; Stock price. (search for similar items in EconPapers)
JEL-codes: D84 G12 G14 (search for similar items in EconPapers)
Pages: 23 pages
Date: 2006-09
New Economics Papers: this item is included in nep-rmg
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Citations: View citations in EconPapers (8)

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