stock prices in a rising interest rate world (II) - Practical Stock Investing

why?should stock prices decline if bond prices do?

The main argument that they should is an economic one?that demand for stocks (or bonds, for that matter) is only one expression of a more basic demand, a desire for savings. ?That demand expresses itself in interest in liquid vehicles like stocks, bonds, or cash, as well as illiquid ones like real estate or hedge funds.

Allocation among investment vehicles is partly a function of individual preferences, partly one of price/expected return. ?In theory, investors change their allocation among liquid alternatives like stocks, bonds and cash depending, at least to some degree, on their perception of relative value. ?So, if bond prices go down (bonds become cheaper), investors will allocate more new money to bonds?and?will sell some of their (now relatively more expensive) stocks to buy bonds. ?Professional arbitrageurs may join in, too. ?This selling makes stocks go down, too.

In the real world, however, this doesn?t always happen.

Look at recent history. ?Stocks are up 150% over the last four years, while individuals have shunned equities and poured money into bonds. ?No judgment of relative value there. ?No consideration of potential future returns.

What about the AAPL bond offering?? Only a few weeks ago, people were more than happy to buy AAPL 30-year bonds with a(n ultra-low) coupon of 3.85%, even though the Fed had been making it clear for a long time that the normal rate on cash should be higher than that. ?No long-term thinking here. ?Those bonds are now more than 10% lower, as sentiment has changed.

end of recession vs. end of the business cycle

When the economy is overheating and chronic inflation threatens (not the situation we?re in now), the Fed raises rates. ?Bond prices drop. ?Anticipating lower profits, stocks also fall.

At the end of recession, on the other hand, the Fed raises rates from emergency lows back to what it judges to be normal (inflation + a real return for lenders). ?Bond prices fall. ?Historically, in this situation stock prices don?t. ?Historically, they go sideways to up, because the Fed?s intention is to remove emergency assistance, not to slow profit growth.

It seems to me that this is a key difference that Wall Street is overlooking so far. ?I can understand why the bond market is upset, though. ?I would be too if I thought that thirty years on cruise control, riding the gravy train of ever-lower interest rates, is over.

does the absolute level of interest rates matter?

Jim Paulsen?s comments that I wrote about yesterday made me think back to a simpler time?the mid-1980s. ?Arguably, you have to go back that far to get a period when markets weren?t distorted by Alan Greenspan?s penchant for very loose money policy.

Back then, it seemed to me that investors looked carefully at the return they could get on a cash deposit vs. what the stock market might offer. ?If money markets began to yield, say, 5%, some market participants would begin to shift money out of stocks and into cash. ?The idea seemed to be that a 5%, 0r a 6%, return that was very likely over the following twelve months and that involved very little risk was preferable to a potential 8%-10% return that required taking the risk of owning stocks.

I don?t know, but it may be that the absolute yield on cash will be a more important consideration again today for stocks than their relative value vs bonds. ?If so, in today?s world, a 4% yield on cash might be the threshold for switching out of stocks. ?Maybe it?s 3.5%. ?But it?s certainly not the current zero.

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Source: http://practicalstockinvesting.com/2013/06/28/stock-prices-in-a-rising-interest-rate-world-ii/

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