Reader Curtis writes “Hello Mish: Can you explain why equities would also go down in a bond market selloff? Wouldn’t equities go up if everyone is dumping their bonds and buying REIT’s, commodities, etc.? They can’t all leave it all in cash.”

Curtis’ question came in response to Red Hot Junk and Massive Bond-Market Dislocations; Equity Smash Coming Up?

Three Base Fundamentals

  1. It is impossible for people to dump bonds for stocks or dump stocks for bonds. For every buyer there is a seller. Someone must at all times hold every stock or bond issued. The exceptions are companies going private, bankrupt, or bought out. Bonds can be retired.
  2. It is impossible for money to flow into stocks or bonds except at issuance (new bonds, an IPO, or secondary offering).
  3. Sideline cash is a function of Fed printing and bank lending. It does not change when stocks or bonds are sold. So yes, it is impossible, in aggregate, for everyone to go to cash.

Equity Psychology

  1. When interest rates rise it tends to slow housing, autos, and consumer purchases. Subprime auto and home sales are particularly sensitive.
  2. When interest rates rise, so does interest expense on the balance sheet of corporations.
  3. Many questionable corporations are in existence simply because they can borrow in the junk bond market. Guess what happens when they can no longer borrow to paper over money losing operations.
  4. Corporations have been borrowing money at cheap rates to buy back shares at extremely expensive prices. Those buybacks lowered the number of shares, boosting PEs. Yet PEs are still astronomical. When corporations can no longer borrow money for buybacks, or get scared about doing them, things start to reverse.
  5. Although people cannot dump stocks, in aggregate, stock prices can fall dramatically simply on the psychology change. At some point, a light goes off and people start to realize the greater fools game is up.

Share Repricing

Think of any down open on the stock market (or for that matter any up open). No shares changed hands except a minuscule amount in pre-market trading.

The shares were repriced. The same thing happens every time the market opens.

Stocks do not go up or down because money comes into or leaves the market. Stocks go up or down based on perceived value and demand for them at the moment.

The amount of nonsense written about sideline cash coming into the market is staggering.

Housing Bubble Repricing Comparison

Think back to the housing bubble when prices held reasonably firm for months after demand dried up. Recall what happened when someone on a block decided to sell a home for $100,000 cheaper. Everyone in the neighborhood was upset at the seller because the whole neighborhood of homes instantly repriced.

Yet, it was not the seller who caused this. Whether or not anyone sold, the price people were willing to pay changed. In actuality, the neighborhood was already repriced. The sale only confirmed what had already taken place.

Money Heaven

People frequently ask “where did the money go”. The answer is often nowhere. Or if you prefer, “money heaven”. Think of a housing subdivision of 500 homes. Let’s say there were no sales or buys for three years.

The worth of homes in that subdivision changed dramatically in three years without a single transaction. No money changed hands. There was an illusion of profit, but it was impossible for everyone to cash out.

Say one seller got out at the top. A few did. They won. Everyone else lost, if for no other reasons than taxes kept going up.

Equity Repricing vs Housing Repricing

The stock market is a bit different because it is a liquid market while homes are illiquid. Equities get repriced every day and people always have a reference.

But like housing, equities are repriced on very little actual volume. And also like housing, only a tiny percentage can get out at the top.

Investigating the Long Haul

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Thanks to the Fed, people have now been conditioned to to the belief that stock prices will always go up over the long haul. That was once the widespread belief about houses.

What if stocks decline a mere 2% a year for 10 years? Far worse yet, what if prices behave like Japan?

Please don’t tell me that’s impossible, because Japan proves it is possible. Speaking of possible, there is no possible escape for the masses if a major repricing event occurs.

Retiring boomers don’t have 15 years, let alone 30.

Question of the Day

How long of a haul is your timeframe?

Mike “Mish” Shedlock