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
- 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.
- It is impossible for money to flow into stocks or bonds except at issuance (new bonds, an IPO, or secondary offering).
- 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.
- When interest rates rise it tends to slow housing, autos, and consumer purchases. Subprime auto and home sales are particularly sensitive.
- When interest rates rise, so does interest expense on the balance sheet of corporations.
- 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.
- 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.
- 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.
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.
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
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
A lot of bondholders and stockholders are on margin of one kind or another. When bonds or stocks are falling, it will reduce their ability to buy more stuff. In 1929, margin calls had a major effect on the original sell-off….
William Foulkes said:
And Hayek warned the NYSE about margin buying, and the NYSE agreed but too lates…
Thanks! Your practical articles like this are very helpful.
Yes, printing is the bank’s war on retirees, and future retirees. The majority won’t outperform the balanced index.
Stuki Moi said:
It’s not really a generational thing. Printing is to an even greater extent the Fed’s war on the young. Who will never be able to buy a place to live at pumped up housing priced, nor ever be able to find a job at the kind of wages necessary to ever be able to buy anything lasting.
It is more correct to state that the printing is the Fed’s war on the non wealthy. Wealthy retirees, who can afford to keep their wealth in the asset classes the Fed is pumping up, without worrying at all about withdrawals, volatility and distributions, are making out like robber barons. It is those retirees who need to manage withdrawals to both survive today, and retain enough to survive tomorrow, who are getting hosed. As are the young who weren’t born with the kinds of silver spoon the Fed likes to pump up to make themselves look good.
Per Desteen said:
The time is coming to change the idea of investment. Practically speaking it has already come, but inertia still has people investing in non-physical investments.
I’m not talking about PM’s or cash, either. Those are nice to have, but they aren’t the future.
The future for an individual investor is local, and it revolves around meeting their physical needs of survival. This includes, but is not limited to:
Tenants living in the same house, ala boarders, etc.
Light duty businesses in the home or on your property.
Sourcing food on your own property, or in your own community.
Small scale, non-cash, or low cost high-tech businesses.
Businesses that leverage the distribution networks such as Amazon.
Living in homogeneous communities that act like communities.
These ideas often require the adult to have children, and work on passing a business and property to children who will stay and make true multigenerational estates.
This is going to come as a shock to the America that thinks of the house with the white picket fence as the pinnacle of culture and the atomization and diaspora away from family that came with it.
If you’ve chosen not to breed, or have only has 1 or 2 kids, you are going to be SOL. Children are an investment, one that’s been treated very shabbily by the boomer generation, but less so by X’ers. Millennials that want to survive are going to have to leverage traditional investments like the family. It could be an easy bargain with parents, in that resources will be traded for support of aging parents.
Also, work must still occur by those parents, if only in a light fashion.
Tony Bennett said:
Some good ideas there … I would add pay down your debt. My #1 “investment” since the recession has been deleveraging both personal and business. Retiring (relatively) high yield debt is most prudent (if you’re not planning to default … and I’m not).
Stuki Moi said:
In addition to the obvious benefits, deleveraging also allows one more breathing room from ever being in a position where one has to accept shitty deals just to get by, but can instead afford to hold out for something less lopsidedly bad. Think payday loans, but in a more generalized sense.
Paul Graham (a genuine smart guy) has opined that a big reason for so many successful startups being started by the very young, often fresh out of college, is that those guys haven’t yet had time to accumulate burn rates that put them under the boot financially before their startup has had a chance to gain enough mindshare to take off. 4 guys to an apartment serving as both living quarters and “corporate head office”, plus a steady supply of Top Ramen, allows one to plug along and explore opportunities lots longer before needing to beg on ones knees in front of some money man, than a flashy office, a receptionist, secretaries and a real salary.
Another factor putting a headwinds on stocks is that as rates rise some of the people trading on margin will sell out. I have co-workers who have been buying dividend stocks on margin. The dividend rate is slightly higher than the margin cost. Plus, they can use the margin cost to offset both short term trading profits and unqualified dividends. Once rates go up this game is over.
Tony Bennett said:
“Those buybacks lowered the number of shares, boosting PEs.”
The buyback story can’t be overemphasized. It is “brain dead” buying … no matter how high the stock price is the buybacks will occur (so much for buy low sell high)
And there is a lot of $$s involved. Factset with latest (Q1):
Quarterly Buybacks Soar 15.1% Year-Over-Year in Q1: Dollar-value share repurchases amounted to $166.3 billion in the first quarter (Feb-April), which represented a 15.1% increase year-over-year and a 15.6% gain from Q4. This marked a new post-recession high for quarterly buybacks in the S&P 500
Companies in the S&P 500 spent $166.3 billion on share buybacks during the first quarter, which marked a new postrecession high. Since 2005, only Q3 2007 produced a larger amount of buybacks ($178.5 billion).
thanks mish, nice article. you may pick up a few new readers as I am going to fwd this to them. you’ve really helped my understanding over the years.
Excellent explanation Mish.
Can you also comment on what impact central bank purchases would have on the market if the Feds follow the lead of Japan and the ECB in purchasing private debt and equities?
STEPHANE CAUSSADE said:
US STXX MARKETS GOING HIGHER THANKS TO THE FED
WHAT ABOUT BEARISH INVESTORS ??
US ECONOMY SLOWING DOWN ACCORDING TO INDICATORS POLITICAL UNCERTAINTIES LESS LIQUIDITY VOLUME ON THE MKTS ETC .. I READ PESSIMISTIC ARTICLES ON VAROIUS BLOGS OR SITES WELL BUT AT THE END OF THE DAY I KEEP SEEING BULLISH STXX MARKETS AND INDICES ON NASDAQ OR NYSE SP 500 GOING HIGHER
SO COULD SOMEONE EXPLAIN ME WHAT IS GOING ON ?
DON T FIGHT THE FED IT IS A GAME AND IF YOU HOLD YOUR POSITIONS A LONGER TIME YOU LL BE PROFITABLE