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April 4, 2005

Why Do Stock and Bond Prices Fluctuate?

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

Why do stock and bond prices fluctuate?

At a basic level, the answer is that prices change so every security that is issued is also held by some investor.

There's more going on than just supply and demand. It's the intersection of the two – equilibrium – that matters. See, it's tempting to think of buying as demand and selling as supply – that buying should move prices up and selling should move them down. When prices are going up, investors often think that “money is coming into the market” as if the market is some sort of a balloon that gets bigger as money blows it up. A moment's reflection, however, makes it clear that both buying and selling are just different sides of the same transaction. Prices move not because of buying or selling per se, since there is exactly the same amount of both in equilibrium. Rather, prices move because, at the previous price, investors would have been more eager to buy than sell, or vice versa, and so the price movement is required to “draw size” from the less willing side. To put the answer in terms of trading volume rather than shares outstanding, stocks and bonds fluctuate to ensure the amount that investors are willing to buy, at a particular time and a particular price, is exactly equal to the amount that investors are willing to sell at that time and price.

A good understanding of equilibrium is important, because it helps to cut through arguments about “money flow,” “cash on the sidelines,” and other common misunderstandings. During the first quarter, for example, we saw a substantial amount of new inflows into growth funds, which a number of analysts have cited as a bullish factor for the market. There are two problems with this. First, while mutual fund inflows are, in fact, correlated with stock returns, they are positively correlated with past returns, and unfortunately negatively correlated with subsequent stock returns. Those correlations are fairly weak for 3-month periods, but get stronger for periods of up to 18-months in each direction. So for example, an 18-month period of market strength is typically related to substantial inflows into mutual funds. In turn, substantial inflows into mutual funds are typically related to below-average market returns over the subsequent 18-month period. (Importantly, there is some actual information content in the inflows themselves, since the correlation between inflows and subsequent 18 month returns is stronger than the serial correlation between past 18 month returns and subsequent 18 month returns).

The second problem is that while money may very well flow into mutual funds of this sort or that, these inflows are exactly offset by reductions of stock holdings elsewhere, whether by institutions or individual investors. This is a simple fact of equilibrium. Aside from new issuance of stocks, when new money goes directly to the issuing company in order to finance real investment in factories, capital spending and so forth, there is no such thing as money moving into or out of the market. As I've noted before, if Mickey wants to sell his money market fund to buy stocks, the money market fund makes the redemption by selling money market securities (like commercial paper) to Nicky, whose cash then goes to Mickey, who uses it to buy stock from Ricky. In then end, Mickey holds the stock that used to be owned by Ricky. Ricky holds the cash that used to be held by Nicky, and Nicky owns the money market securities that used to be held by Mickey. Now, depending on who was more eager - Mickey, Nicky, or Ricky - prices may or may not have changed. But one thing is certain, there is still exactly the same amount of “cash on the sidelines” as there was before the transactions occurred.

[As a sidenote, the gross domestic investment - plant, equipment, capital spending, real estate, etc - in the economy is exactly equal to saving in the economy (including imported savings from foreigners). So for instance, the savings that people create through their 401K programs and so forth do finance real investments, but those savings need not increase the value of stocks and may not even be of benefit to stock-issuing corporations at all, even if the savings are invested in stocks. For instance, if Mickey (who is a construction worker) invests new savings in a stock mutual fund through his 401K, the fund goes out and buys stock from Ricky, who gets Mickey's cash and invests it in a money market fund, which buys debt securities issued by a government agency, which purchases mortgages made by Nicky's bank, which lends the cash to Nicky, who uses it to pay construction workers to build a house. Though that route was more direct than most, savings really do equal investment for the nation as a whole. The economy is basically a big karma train].

Myopia

If we dig a little bit deeper, and think about what motivates buying and selling, we can also say that stock and bond prices move in order to align the expected, risk-adjusted returns of various assets over time. Put simply, there's a competition between every stock, bond and other security, and all of their prices fluctuate so that on the whole, the market doesn't view the expected return on any security as too high or too low relative to the others. So for example, if the market, on the whole, thinks that a particular stock's price is too low (i.e. it's long-term expected return is too high) relative to where other securities are trading, the desire to buy the stock at that price will outstrip the supply at that price, and so a price increase (and a reduction in the long-term expected return) will be required to increase supply and reduce demand enough to get back in equilibrium.

Over time, the endless competition between stocks, bonds and other assets leads to a market that is more or less efficient in the long-term (though that's far weaker than saying that all securities are priced efficiently at all times, which I don't believe at all). Over the short-term, however, the competition between securities can become inefficient and even pathological when investors form their expectations about future returns with no regard to valuation.

One way investors do this is by extrapolating recent trends. Clearly, when investors begin arguing that the market should go up because the market has gone up, there is bound to be trouble. The situation is nearly as bad when investors assume that historical returns are “given,” and that stocks will be a good investment because they have been a good investment. Probably the greatest risk to investors both at the 2000 market peak and at present is the failure to recognize how important rising P/E ratios – rather than earnings growth per se – have been in producing the stock market returns seen during the past quarter-century, and how unlikely it is for total returns on the S&P 500 to exceed the mid-single digits over the coming decade.

In recent years, both stock and bond investors have also abandoned careful valuation analysis in favor of what's called the “carry trade.” Essentially, the carry trade involves buying a long-term investment and assuming that its valuation will not change. So long as the expected return from carrying the security is higher than short-term interest rates, the carry trade is then expected to be profitable. In bonds, the carry trade amounts to investing in long-term bonds when the yield curve is steep. In stocks, the version of the carry trade in most investors' minds amounts to investing in stocks so long as the sum of earnings growth and the dividend yield (the total return on stocks, provided the P/E doesn't change) is expected to be above Treasury bill yields. (As a practical matter, it turns out that stock prices have little or no correlation with earnings except over the very long-term, so there is rarely a basis for being bullish on stocks simply because one is bullish on short-term earnings growth).

Clearly, the carry trade is pure myopia, and factors in neither the risk that valuations will change, nor the risk that short-term interest rates will increase and wipe out part or all of the (perceived) advantage. Still, short-term interest rates have historically demonstrated more impact on stock and bond prices than they should in an efficient market, which suggests that investors do respond to this sort of myopic “opportunity.”

Unfortunately, because it fails to respond sufficiently to valuation risks, the carry trade often unwinds at a loss when short-term interest rates increase. It is clear, for example, that the combination of low stock yields and rising short-term interest rates has been historically dangerous for stocks (particularly when inflation and other competing yields have also been rising).

Back to equilibrium

Given that all stocks and bonds issued must also be held (prices fluctuating to ensure that this is the case), we can already see important risks. First, the U.S. continues to observe inflation pressures on the basis of oil prices, and the risk of a weaker dollar is likely to increase these pressures. Despite tepid employment figures, enough workers continue to leave the labor force to keep the unemployment rate down, and with little obvious softness in demand growth, the Fed is not likely to taper the gradual increase in short-term interest rates. So long as the yield curve flattens overall - even if both short and long-term yields increase - the carry trade in bonds is at risk (and it's not clear at all that the carry trade in bonds has been unwound). Since whatever bonds sold to close those carry trades have to be bought by other investors at yields that induce them to buy, it appears that in the absence of fresh economic weakness (and also in the absence of speculative demand, based on our analysis of market action), long-term bonds continue to be at risk of a bearish flattening - where the yield curve flattens by long term rates rising, though at a somewhat slower pace than short rates.

We also continue to monitor risks related to the central bank policies of China and Japan. During the 1960s through the mid-1990's, U.S. investors held between 80% and 95% of publicly held U.S. Treasury securities. Over the past few years, that figure has plunged to nearly 50%, as foreign central banks have increased their purchases – with that inflow of foreign capital financing nearly every dollar of growth in U.S. gross domestic investment since the mid-1990's.

The carry trade has clearly been important in the foreign activity too, especially for Japan (given its own interest rates are close to zero). But a carry trade that relies on stability in U.S. long-term bond prices and in the U.S. dollar itself is not a dependable investment when a more diversified alternative is available. Even without actual sales of existing holdings, a reduction in the pace of foreign capital inflows remains a persistent risk for U.S. gross domestic investment. Meanwhile, the U.S. government will continue to issue new debt. Since all of this issuance must be held, any change in foreign central bank policies will make bond prices susceptible to weakness, since U.S. investors would have to be induced to increase their investment share in U.S. Treasuries from 50% of the float back to some higher proportion of ownership.

In stocks, the upward pressures on interest rates and inflation are also of concern, particularly since stock yields remain quite low. Among historically dangerous conditions for stocks, there's nothing quite like low stock yields coupled with rising yields on competing assets, particularly when market internals are deteriorating, as they seem to be here. As usual, that isn't a forecast that the market should or must decline over the short-term. Rather, it implies that investors should allow for potential market weakness, and that risk management is an essential consideration here. My weekly comments of the past few months have also emphasized the long-term risk of disappointing stock returns, and that continues to be a major consideration.

From an equilibrium standpoint, the extent of the stock market's overvaluation is very problematic. It's clear that much of the demand for stocks in recent years has been based on speculative rather than investment considerations. The difficulty is that when speculation wanes at high valuations and investors start to become more risk averse, the supply of stock doesn't meet with a natural pool of demand. In order to draw demand from value-oriented investors, stock prices would have to be substantially cheaper, and the possibility of arriving there quickly can't be ruled out. Again, these comments should not be taken as forecasts, but it is certainly not encouraging that historically, major declines in stock prices have generally emerged from the present set of conditions: high valuations (low stock yields), rising interest rates, and deteriorating market internals.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations, coupled with tenuous and still deteriorating market action. The mid-week rally last week was accompanied by such poor internal action that I clipped off the call option position purchased at the end of the prior week. At present, the Strategic Growth Fund is still not fully hedged, but suffice it to say that in the event of a further decline, the difference in return between our current position and a fully hedged one would be expected to amount to less than one-quarter of 1%. In short, the current Market Climate is statistically indistinguishable from what we would arrive at with more negative confirmation. Still, if the market were to recover with good internal action (which I don't rule out and neither should you), we would quickly move to a more constructive investment position. For now, however, we've aligned ourselves with prevailing valuations and market action, which leave the Fund in a defensive position until sufficient evidence emerges to change that stance.

In bonds, the Strategic Total Return Fund continues to carry a short duration of about 2 years, mostly in medium-term Treasury Inflation Protected Securities (a 100 basis point move in interest rates would be expected to impact the Fund by about 2% on the basis of bond price fluctuations). The Fund also holds approximately 16% of assets in precious metals shares, which continues to be a limited but important component of our investment stance here.


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