What Moves Markets

There’s a lot of analysis in the financial press statistically describing how the prices of financial asset classes correlate to each other.  Financology discussed correlation in An Investing Primer.  Here we’ll turn to the question of why these things act the way they do in order to help us better understand what to expect.

Stocks and bonds are both claims on future cash flow streams. In the case of bonds, that cash flow is fixed. For stocks, it’s variable. To draw some view-from-35,000-feet generalizations, let’s assume that the cash flow from bonds is constant in nominal terms, and that the cash flow from stocks is constant in real terms.

This gives us a basis to see what accounts for both positive and negative correlation. The definition of interest rates is that they relate the value of present and future money, including the relative value of present money (price) and future cash flow (coupons or dividends). So broadly when interest rates (both immediate and expected) change, the present value of both bonds and stocks changes, All else being equal, the value change would be the same for both. Positive correlation.

Next let’s assume that inflation expectations change while interest rates remain constant. If expected inflation rises, the real cash flow from stocks is unaffected, but the real value of the cash flow from bonds declines. This changes the relative current value of stocks and bonds … stocks will rise in price and bonds won’t. But since increases in interest rates are likely to follow increases in inflation expectations, bond prices will likely fall. Conversely, if expected inflation falls, stock prices are likely to decline while bond prices increase. Negative correlation.

Financial markets are driven fundamentally by ongoing shifts in interest rates and inflation expectations, both on a short term and long term basis. As new information streams into the marketplace, one changes, then the other, and price movements flow from one side to the other in waves. Markets also move on momentum since there are many investors who don’t act on fundamentals per se but rather the actions of other investors. So once a trend gets going, it usually goes further in the same direction than is justified and reversion towards the fundamental tendency occurs. Both positive and negative correlation forces between stocks and bonds are present at all times, but they take turns predominating over both short and long term time frames. Usually long term correlations are more positive and short term correlations are more negative.

There is one other wrinkle, though … duration. Suppose you have a bond that you pay $1000 for and it pays you back $30 a year in perpetuity. And suppose you expect zero inflation over this period. In this environment, a stock that pays $30 a year in dividends should also be worth $1000.

If positive inflation is expected, the price of the stock will be higher. It may fetch $1500, making the short term yield 2%, but its dividends will rise in nominal terms making it competitive with a bond yielding 3%. The duration wrinkle is that most bonds aren’t perpetual, they have fixed maturities at which point they will return all the principal. If you maintain a portfolio of bonds of one year maturities, every year you replace them with new bonds at the prevailing yield. As a result of the ability of the cash flow to adjust to rates this portfolio changes very little in price and may be described as “low risk”.

So if you’re in a period of very low interest rates, both stock and bond prices are very high. But a bond portfolio may still nevertheless be lower in risk because while stocks are almost always long duration assets, your bonds may not be. Even though bonds and stocks may be equally richly valued, there is still benefit from owning bonds as well as stocks because of this lower risk. The ETF GOVT, for example, holds Treasuries from 1-30 years maturity, in market weights so that the maturity and duration are in concentrated in the 3-7 year range. Because of the turning over of short term bonds, even though the price has declined 3-4% this year, interest distributions have been growing at a 15-20% annual rate.

Real physical assets like gold have zero duration. There is no future cash flow involved. So no interest rate factor, just inflation. This results in their having a price behavior profile unlike either stocks or bonds and therefore the potential for further diversification benefit.

Cash, as in physical currency and money in checking accounts, is also an asset of zero duration.  Checking accounts, more broadly referred to as “demand deposits”, are also called “current accounts” for this reason.  Again, inflation is the only driver of value, but in this case it’s better to look at it the other way around … changes in the value of the currency are what cause changes in the general price level.  If the currency depreciates, we call it inflation; if it appreciates, it’s deflation.  But unlike the case with the other asset classes, these changes are normally obscured from direct view because of our habit of using the currency itself as our unit of measuring value.  It can’t be emphasized enough that this is an arbitrary choice … our money is a financial security not unlike a stock or a bond and it changes in value just the same.  In contrast to other securities though, we observe those changes in value not as a “price” of the dollar, but in the prices of other things.  If for instance the prices of stocks, bonds, copper, gold, etc. all move in the same direction, we could just as well conclude that the main mover was the currency unit we used to measure those prices with, as opposed to some metaphysical conspiracy between these fundamentally different things.  If our dollars change in value, and we use dollars as a pricing unit, it’s manifested not as a change in the price of a dollar (that’s still a dollar), but in the changes in the prices of other things.  For more on this, see Measuring Inflation.  

There’s one other wrinkle that needs our attention.  Most corporations are capitalized with both equity and debt.  This means that their stock is not a pure equity investment, but one with an embedded negative position in bonds.  It has built in leverage.  So to get to just neutral in terms of equity exposure, an allocation to stocks would have to be balanced with some allocation to bonds.  The amount varies over time, but here in 2018 this is an especially significant issue because corporate America is carrying record levels of debt.