Which Will Break First, Stocks Or Bonds?

(By Rich Bieglmeier) S&P/Capital IQ's Chief Market Equity Strategist, Sam Stovall says something has got to give.
 
In a recent video, the stock market veteran discusses the disconnect between equity prices and bond spreads. He equates the current situation to an earthquake survivor staring at the cracks in the surface coming at him and supposing the cracks will swerve around him, rather than staying on course and moving right below the dazed pedestrian.
 
Since the short-term market bottom, stocks have advanced despite rising global equity risks. Stovall notes that through June 20th, the S&P advanced more than 3.5%, all 10 major sectors made gains, and 86% of the 132 sub-industries are green.
 
The stock market gains come despite yields on 10-year US treasury notes flirting with historic lows. The guru points out that stocks typically "tank" when bond spreads spike. FYI - bond spreads are the difference in yield between bonds of different credit quality, usually some corporate bonds versus a risk-free rate i.e. US Government Bonds. For example, the yield of 10-year Treasury notes versus 10-year investment grade corporate bonds average yield.
 
When the difference widens, then it is said the environment is more risky for equities. Perhaps, you have heard the talking heads call it something like "risk-off," meaning institutional investors are more risk averse than usual.
 
On the "risk-on" side, the difference between the risk-free rate and corporate yields narrows, which means it's safer to wade into the dangerous waters of stocks.
 
Anyway, enough with the classroom lecture. Mr. Stovall says bonds are acting like the earthquake will engulf the European Union, while stocks are saying a passing heavy truck is responsible for the windows rattling.
 
If the bond market is wrong, then the cracks will swerve, and stock prices will have plenty of ground to gain. On the other hand, if the boys and girls of credit are right, then stocks could go boom – something has to give.
 
S&P's believes it might be a little tug here and there on both sides as their second half forecast is for stocks to make "a very choppy" advance. iStock isn't so sure which side will win out at the moment. We will reserve our judgment for the rest of 2012 until 2nd quarter earnings season is in full swing and we have some clue regarding the resolution of 2013's fiscal cliff.