What's Behind Those Shaky Stocks?
For investors accustomed to the stock market's surprisingly smooth ride in recent years, last week was a wake-up call.
With the bond market selling off on inflation fears, the stock market experienced a bout of sympathy pains. The Dow Jones industrial average plummeted more than 400 points between Monday and Thursday.
Then on Friday, cooler heads prevailed. Once stock investors finally realized that inflation wasn't that big an issue, the Dow rallied by more than 157 points.
So what exactly was going on last week?
Simple: The bond market cried uncle.
For more than a year now, the bond market has worried that the economy is in much bigger trouble than the stock market or even the Federal Reserve thinks it is. The sad state of the housing market heightened those fears.
As a result, bond investors snapped up ultrasafe long-term U.S. treasury bonds to seek shelter from an anticipated economic storm. That pushed bond prices higher while driving long-term bond yields lower—to the point that at the end of 2005 and the start of 2006, the yield curve inverted, with short-term bonds paying out more in yield than long-term debt.
Long-term bonds normally pay investors higher yields than short-term debt, since long-term securities expose investors to greater risk. But fixed-income investors grew so worried about the economy that they didn't care what long-term treasury bonds were paying out—they simply wanted to park their money in these safe assets. So, their buying drove down long-term bond yields at the same time that the government was raising short-term interest rates to keep inflation at bay.
Hence, the yield-curve inversion, typically a sign that recession is just around the corner.
But last week, bond investors were selling the very instruments they had bought to seek shelter, and the yield curve began to return to its normal slope. By Friday, the yield on 10-year treasuries had jumped to 5.12 percent, while two-year treasuries were paying out 4.99 percent.
In effect, bond traders admitted that their forecasts about a major economic slowdown were incorrect. "Those of us in the bond market got it wrong," says Marilyn Cohen, chief executive of Envision Capital Management, which manages fixed-income assets. "We thought that once the housing market fell out of bed, we would see slower consumer spending. But that didn't happen to as large a magnitude as we thought."
James Paulsen, chief investment strategist for Wells Capital Management, notes that historically, "the bond market has developed a greater reputation for being accurate and exact whereas the stock market is thought of as an emotional beast." But this time, the stock market got it right by rallying on better-than-expected economic news in recent months.
So why did the stock market sell off between Monday and Thursday last week?
Several explanations are possible. In part, it was simply a case of being startled by the extent of the bond market sell-off. Another is that stocks and bonds compete for investment dollars, and with bond yields starting to move higher, equity investors may have feared that some money might soon move out of stocks and back into bonds.
advertisement
