The information content of the stock and bond return correlation

Abstract

We believe that the correlation between stock and bond returns carries information for the future values of these return series and economic conditions more widely. The correlation reflects investor perceptions regarding future economic performance, with a declining and negative correlation indicating heightened economic and market risk. Using US data from 1900, we show that the correlation has predictive power for subsequent stock and bond returns and can be used in a market timing strategy to improve portfolio performance. Moreover, the correlation also predicts bear market periods. Further, the correlation contains predictive power for a set of key macroeconomic variables, and has predictive content for contractionary periods. We believe the results in the paper are of interest and relevance to academics, practitioners and policy-makers.