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."


And a section on correlation:

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.

David Fuller's view After a traumatic event such as 2008's market meltdown, many investors will be looking over their shoulder for a repeat over at least a year or two. I mentioned this prevailing psychology last week. Similar fears persisted after the plunge in 1974, the Crash of '87 and the bursting dotcom bubble in 2000. There are also people who missed the bottom in 4Q 2008 and 1Q 2009, and therefore have a vested interest in a return to those lows.

They could be right as there is no shortage of serious problems out there, of which we are reminded every day. However these are mostly confined to the more indebted OECD countries. The new growth engines of emerging Asia and resources exporters are doing rather well.

Moreover, I would be very surprised to see the USA, and Central to Northern European stock markets retest their 2009 lows against the background of low short-term and low long-term interest rates, unless these economies are about to slide into a Japan-style deflation. This too is theoretically possible but certainly not a destiny, particularly as the risk has been widely recognised by monetary authorities.

Consequently, I am in general agreement with the more optimistic views expressed in the Bloomberg article above, although not necessarily in the short term. However I hope to see technical confirmation of renewed upside potential in 4Q 2010, if not sooner. If so, the upside is likely to be led once again by some of Fullermoney's favourite markets.