The Speculator
What's good for bonds
is good for stocks
Both stocks and bonds have been doing well of late,
a situation that many experts think is at best troublesome and at worst a sign
of doom. The numbers tell us the opposite is true.
By Victor
Niederhoffer and Laurel Kenner
Here’s one for the Dead Myths Department: “Stocks can’t rise when bonds
yields fall, because economic weakness is good for bonds and bad for stocks.”
The
last several weeks have exploded that story. From March 31 through May 16,
stocks rose 11% and bond prices rose 6%.
Since mid-2001, the myth had seemed to be in accord with reality. Bonds
rose some 19% as stocks declined 23%. Here are the months in which 30-year bond
futures showed a rise of 1% or more, along with the change in stock futures
during those months.
The exception
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In fact, as we wrote in a May 17, 2001, column (“How the Fed’s moves shake markets”),
the relation between bonds and stocks is a subtle one.
Myths are created to explain the unfathomable: things like birth and
death. Their function is to keep people content and servile. And the market
needs to keep investors servile so that they willingly pay its massive overhead
in compensation, equipment and research by trading the wrong way.
It’s not surprising, therefore, that the bond-stock myth has given birth
to a new, equally awe-inspiring, equally destructive myth guaranteed to put
investors on the wrong foot. The new myth is that the United States is headed
for a deflationary implosion. With prices constantly decreasing, the story
goes, businesses will be unable to make a profit. As in Japan during the last
20 years, decision-makers will be reluctant to spend no matter how much effort
the central bank exerts to expand liquidity.
As the story-telling economist Paul Krugman told the tale in a New York
Times column at the start of the year:
Here's how it can happen: First, for
whatever reason, the economy becomes depressed. The central bank responds by
cutting interest rates -- but it turns out that even cutting rates all the way
to zero isn't enough to restore more or less full employment.
At that point, the economy crosses the black hole's event horizon: the point of
no return, beyond which deflation feeds on itself.
Prices fall in the face of excess capacity; businesses and individuals become
reluctant to borrow, because falling prices raise the real burden of repayment;
with spending sluggish, the economy becomes increasingly depressed, and prices
fall all the faster.
We know from Japan's experience that the descent into such a black hole is a
gradual process.
It
seems only yesterday that Krugman and other purveyors of doom were predicting
that the coming surge in interest rates would lead to a housing catastrophe
that would destroy the recovery and sink the market. A quick Google search
shows that we are not putting up straw men; some 56,000 stories mentioning
deflation and stocks have appeared in the past three months.
The myth that falling prices will lead to a 1929-style crash has old
roots. In “The Social Consequences of Changes in the Value of Money,” an essay
published in a 1932 collection, "Essays in Persuasion", John Maynard
Keynes wrote: “The fact of falling prices injures entrepreneurs. Consequently,
the fear of falling prices causes them to protect themselves by curtailing
their operations.”
We object to the deflationary spiral story on theoretical, empirical and
statistical grounds.
Theoretical grounds
Falling prices are good in the same way that rising prices are bad. Lower
prices increase our purchasing power: We can buy more suits and butter with the
same income. Businesses can buy raw materials at cheaper prices. Thus, reduced
prices represent an increase in the real wealth of consumers and businesses. At
the most fundamental level, improvements in wealth are all to the good because
they are one of the main components of the pursuit of happiness, held since the
Declaration of Independence to be one of the three most important American
values.
At a more mundane level, increases in wealth are good because they lead to
more spending and more jobs. A good working model is provided by the quantity
theory of money:
Given a relatively consistent money supply, price times trade is a
constant.
When prices go down, trade (or output) goes up.
Price declines are caused by innovation, improved productivity and
vigorous competition -- all highly desirable in a non-command economy.
Empirically…
A look at the United States’ economic history further serves to debunk the
deflationary spiral theory. From 1870 to 1900, wholesale prices decreased by
about 30% and output tripled.
Economic historians agree that this period showed the greatest relative
increase in output and standards of living of any comparably long period in
American history. It is no accident that this period of deflation was
accompanied and spearheaded by the Industrial Revolution. (This is a good fact
to have handy the next time a myth-maker tells you that the robber barons of
that period -- the Carnegies, Fricks and Rockefellers -- were rapacious
price-gougers. A good discussion of these trends is available in the book
"American Economic History" by Jonathan Hughes and Louis P. Cain.)
No matter what we say about the theoretical and empirical facts, the
myth-makers are certain to treat them with disdain. Such was the case when we
reported on the highly bullish backdrop provided by such things as the low
level of supply of stock relative to debt (“Why stocks should rise 19% this year,” April 20, 2003), the
spread between forecast earnings yields and government bond yields, and how no
amount of good information can possibly turn any of the bears from their
preconceived views.
These columns lead to threats and hateful comments of all stripes directed
personally at us; even civil readers reacted negatively. We therefore fully
expect readers to write in that our economic analysis cannot be correct, that
most economists including numerous Nobel prize-winners are predicting -- dare
we say hoping? -- for a Japan-style deflationary depression.
Therefore, we will put our statistics on the table. As Steve Stigler puts
it in a passage in the book "Statistics on the Table" we can never
quote often enough:
"If a serious question has been raised, whether it be in science or society, then it is not enough merely to assert an answer. Evidence must be provided, and that evidence should be accompanied by an assessment of its own reliability. This test requires more than simple number collection. It involves a careful analysis of the forces that would affect any data, methods for measuring and expressing the uncertainty of the conclusions, and conventions for settling issues such as how much uncertainty is too much, or when an assertion should be rejected and when not."
Our statistics on the table
With our pencils and backs of envelopes at the ready, we begin by noting
that it has not always been believed that bond and stock prices move in
opposite directions. For 18 of the 20 final years of the old millennium, bonds
and stocks moved in the same direction. Indeed, the correlation between yearly
returns in bonds and stocks during that period was a very high 75%.
Here is a table showing every occasion in the 1990s that 30-year bond
futures showed a monthly return of 2% or more, along with the change in stock
futures that month:
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When bonds rise … |
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As the table shows, during the 24 months in the 1990s when bonds
registered their big moves, the average move in stocks was 2.5%. During the
entire decade of the 1990s, when stocks and bonds were highly correlated, the S&P
500 ($INX) rose 315%.
But that kind of study is descriptive, not predictive. We therefore
returned to the 1990s to see what happened to the S&P 500 the month after
the 19 months in which stocks rose in connection with bonds (as they have so
far in May 2003.)
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… Stocks rise, too |
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Thus, the statistical facts reflect our economic and historical arguments.
Far from the new paradigm being the harbinger of doom, it has been a
concomitant of boom.
As we write, bonds are up some 5% in May, while stocks are up 2%. It looks
like we’re back to the 1990s kind of model, where bond and stock prices move in
the same direction. From a long-term point of view, the 1990s was a very good
period for stocks. In the short term, it’s about 2 to 1 that stocks will go up
in June, with the mean change (around which there is much variability) being
about 1%.
Final note
We have complete data for bonds and stocks by month from January 1990
available to the present available on our Web
site. Our book, Practical Speculation, contains descriptions and
explosions of numerous other market myths. Please e-mail
us at with other market saws that you suspect might be mythical or
would tested. We answer all correspondence.