One of the old maxims about the stock market is to stick to things you know best. Whether that be small-cap mining companies, technology stocks, or even just sticking to the blue-chip names.
With over 2,000 stocks on the ASX, there just isn’t enough time to run the rule over them all.
By getting to know a section of the market, you know what factors influence prices. Like a crop report, a pickup in demand, or a competitor cutting back production. All find their way into a stock price.
Of course, you can still invest outside the sectors you know best. It does, however, make it hard to match it with those who trade in that sector every day.
Whichever you focus on, however, it’s easy to miss something that affects the broader market. That is, the flow of money between asset classes.
So much of the current debate about whether the stock market is overcooked comes down to valuations. That is, the multiple that a share price (or the market) is trading over its earnings.
A small business might not be worth any more than two or three times its annual earnings. However, the stock market can be much more generous than that.
Take Amazon.com, Inc. [NASDAQ:AMZN] for example. It currently trades around 360-times its earnings per share. Even companies that don’t make any money at all can still attract a lofty share price.
While earnings of course matter, the flow of money also plays a big part in what share prices do.
Stock investors are typically familiar with another major asset class — property. Not just because they might have first bought their own house before ever venturing into shares. But also due to the strong place property holds in our minds.
You often see median house prices and auction clearance rates reported in the news.
However, one asset class that many investors are less familiar with is bonds. They are something that you are unlikely to see quoted anywhere — often not even in a finance report.
The thing about bond markets
For some, bonds are a bit confusing. They don’t quite get why bond prices fall when yields go up. It all seems a bit back to front or upside down.
It also has a lot to do with accessibility. Opening an online share trading account is a pretty straightforward exercise. But where do you buy a bond…and how do they work?
The thing about bonds is that they matter a great deal to the stock market. And much of that has to do with the size of this asset class.
The global bond market is much bigger than global stock markets — almost double the size. As an example, PIMCO — perhaps the best-known bond manager — oversees in excess of $1.75 trillion in funds. Yet this represents less than 2% of the global bond market.
For us, if we are worried about the market, we can always sit it out. However, those that manage the trillions of funds in superannuation accounts and mutual funds worldwide don’t have that luxury.
For them, they can’t just take their money off the table and put it in the bank. Instead, they have to decide among a finite number of asset classes where best to invest those funds.
And that is why the bond market is so important. At double the size of stock markets, a change in bond money flow has big implications for these other asset classes. If money starts coming out of bonds, it needs to find its way into something else.
The reason why this money flow might all be about to change has to do with yield. Yields have been creeping up slowly since July 2016 — a reversal of the bond bull market that went for almost 30 years. As yield goes up, the value of a bond goes down.
Typically, bonds pay a fixed interest rate, set at the time of issuing the bond. If you buy a bond with a 3% yield, and rates increase to 4%, the value of your 3% bond goes down. That’s simply because you can buy a bond with a higher yield (4% in this example) instead.
If the Fed in the US raises rates another couple of times this year — as the market expects — the value of current bonds (with lower rates) will continue to go down. The funds that own huge quantities of bonds might look to exit and invest their money elsewhere.
This can go two ways for the stock market. A chunk of these funds could flow into shares, helping to propel the bull market higher.
However, the money can also flow the other way. If fund managers believe the stock market has topped out, they might deem it safer to park funds into safer-haven assets, like bonds.
For a market like the US that trades on yields of around 2%, a bond paying anywhere from 2.5–3% might prove an attractive alternative. Meaning managers might pull funds out of shares and put them into bonds.
Buying a bond might not be for everyone. You might choose to invest in something that you understand better like shares.
If you do want to invest in bonds, though, and don’t know how, you can do so through ETFs.
With the weight of money that sit in bonds, however, a big change in the money flow has the potential to change the direction of the stock market. Meaning that whether you choose to invest or not, share investors still need to keep an eye on the bond market.
All the best,
Editor, Total Income