CAPITAL IDEAS: What is the bond market saying about the stock market?More Info
Dalton — In June of 2007, when stock market indices were near all-time highs prior to the Great Recession, I started to short the market (i.e., buy investments that go up in price when stock prices go down). I made that first bet that stocks would go down not because of what I saw in stocks, but because of what I saw in bonds.
To be sure, we were tracking signs in both the economy and stocks before the bond market triggered action. The economy was great, and while breadth was deteriorating (the number of stocks going up were falling), the major indices were at or near all-time highs. But the bond market was getting a bit too wonky for my taste. The final straw was that I was trying sell a Ford bond online and the price wasn’t as attractive to me as I expected it to be. I called the Charles Schwab & Co. trading desk to see if there was something wrong with their online ordering system. Nope. I couldn’t get a good price on a Ford bond, a very liquid bond. And by “good price” I mean a few bucks off. There was no company-specific news to attribute it to. I asked them to get me prices if I wanted to sell or buy some other bonds, and those prices were also askew. Sure, liquidity was drying up as a massive amount of cash was either flowing to stocks or real estate, and decreased liquidity means more volatility. But the liquidity drought wasn’t enough to throw off bond prices overnight. So I shorted the market before the Great Recession and the rest, as they say, is history.
The bond market is, again, saying something about the stock market. Do you want the good news or the bad news first? Let’s start with the good news. Or maybe it’s mixed. In 2007 the economy was strong and although there was internal technical weakness, stock market indices were flying high. Today the international economy is awful (the U.S. does remain a global standout on a relative basis for now) but, nonetheless, the U.S. stock market’s near highs are supported by technical factors. The bad news? Bonds are acting up again not in terms of prices, but in terms of liquidity. That matters because it’s a warning sign of the actual warning sign, which is bond price volatility.
The average daily volume for high yield bonds has fallen 18 percent from two years ago, and the average daily holdings have dropped 80 percent from five years ago. There has been a drop in one or both of volume and holdings for all of the following bond categories: non-agency residential mortgage-backed securities, investment grade, Treasury bills, commercial mortgage-backed securities, asset-backed securities, commercial paper, and residential mortgage-backed securities. This is one of the reasons my firm has avoided direct investment in the financial sector and European stock markets up to now. The loss of market share has weighed on bank trading revenue. And just as the U.S. markets are heavy in tech stocks, European markets are heavy in financials.
I’m a dumb human
Corporate bond liquidity is bad—real bad. It’s not enough to tell me that a recession is coming in 2019, but it’s an indication that the probability is rising for a recession in 2020 or 2021. Essentially this is a leading indicator of a leading indicator. I like to look at such geeky things not just because it’s good research, but because I’m a dumb human. It takes us dumb humans a long time to change our minds. Sometimes we never change our minds, even when presented with evidence that is absolute and certain. We’re all guilty of it, no matter how smart we are in other areas. Ph.D. candidates are notoriously guilty of this. When they write their dissertations, they will research their hypotheses. The data that supports their hypotheses is collected and footnoted and treated as if it’s brilliant because, after all, it supports their narratives. Data that does not support the candidates’ hypotheses is weighed less in its importance as they rationalize that the evidence was authored by someone of lesser stature, or (ironically) the study was prone to some sort of bias, or they’re quicker to see a flaw in the methodology of collecting that evidence.
We dumb humans do this on a personal level, too. We all have someone in our lives who we love, and we all have someone we don’t love. Those two people can do or say the exact same thing, let’s say it’s a bad thing, and we’ll use it to support our idea that we don’t like the “bad” person, but if the someone we love, the “good one, says or does it, in our minds, they just had an off and excusable moment. We don’t like to change our minds; we’re awful at it. But sometimes we will change our minds if we have enough time and evidence to prompt us.
The hardest part about investing isn’t finding new things to buy. That’s easy. It’s the “when” to buy that’s hard. A harder part is changing your mind about something you own, figuring out when to sell it. One day you own something, which means you (hopefully) made a decision based on research. Some other day you must change your mind and recognize that your good idea turned bad. Perhaps the investment ran its course, or the information turned on you, or you were just wrong from the start. That’s hard for a lot of people to do, so they default to inaction—that is, until the price goes down and the good investment return is now a loss (or, at least, less good). That’s when most people sell an investment—after something has gone down in price. The No. 1 reason people buy a stock is because it goes up in price. And that’s the main reason people are bad at investing. According to a 2017 study by Dalbar, the average investor earns returns well below the stock market averages.
As you know, I feel that if your only financial need is investment performance, you don’t need a financial advisor. Buy a bunch of inexpensive, tax-efficient ETFs that track the stock market indices; make regular contributions to your portfolio; and don’t trade your investments. But I know some of you are adventurous and like to buy and sell. That’s fine. I just want you to know that you can improve your odds of getting better performance by allowing for the inclusion of research so that your human brain can be prepared to make a rational decision instead of buying something just because you know the name of the company or because the price movement prompted feelings of fear or greed.
Allen Harris, the author of ‘Build It, Sell It, Profit: Taking Care of Business Today to Get Top Dollar When You Retire,’ is a Certified Value Growth Advisor and Certified Exit Planning Advisor for business owners. He is the owner of Berkshire Money Management in Dalton, managing investments of more than $400 million. His forecasts and opinions are purely his own. None of the information presented here should be construed as individualized investment advice, an endorsement of Berkshire Money Management or a solicitation to become a client of Berkshire Money Management. Direct inquiries to firstname.lastname@example.org.