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Why are stocks going down and bonds going up?

 
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arthur
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PostPosted: Tue Jan 25, 2005 8:18 pm    Post subject: Why are stocks going down and bonds going up? Reply with quote

By Dr. Irwin Kellner, MarketWatch
Last Update: 9:40 AM ET Jan. 25, 2005

HEMPSTEAD, N.Y. (MarketWatch) -- When bonds are up and stocks are down, it's time to sit up and take notice: these markets are telling you something.

This has been an unusual January, to say the least.

Instead of rising the way they usually do at the beginning of the year, stock prices have taken a header. And instead of falling as you might expect when the Federal Reserve is withdrawing monetary stimulus by raising short-term interest rates, bond prices have gone up.

The last time the Dow Jones Industrial Average fell during January's first three weeks was way back in 1982. For those readers who might not remember, that was a recession year - indeed, the worst since the 1930s.

If the entire month is negative - which seems increasingly likely - it will set off some technical alarm bells. Market mavens believe that as January goes, so goes the year, so a weak January would seem to presage a down year for the stock market. Read more about the January effect from Mark Hulbert.

Although stock prices are determined by many factors - not the least of which is that intangible called market psychology - the overriding element seems to be the outlook for corporate profits, and thus the economy.

Earnings gains are slowing from their earlier pace (see last week's column), while the economy's growth rate is moderating as well (see Jan. 11 column).

What's more, because the stock market not only leads the economy, but it influences it as well through the wealth and confidence effect, you can expect falling stock prices to be a drag on economic activity as well.

Not every decline in the stock market has led to a recession, but most - if not all - recessions have been preceded by a drop in equities' prices.

As for bonds, the fact that their prices have held up might at first blush appear to be a countervailing force to falling stock prices. This is because long-term interest rates have drifted lower, thus helping such interest-sensitive sectors as housing remain afloat.

True enough, but falling yields and rising bond prices at a time of tightening monetary policy could also signal weakness in the economy down the road.

The bond crowd would not allow yields to fall if they thought economic growth was strong. Rapid growth at this point in the cycle usually leads to a pickup in the rate of inflation, which, as you know, is anathema to the fixed-income markets.

To make matters even more interesting, the yield curve, the term structure of interest rates, has flattened considerably over the past half year. When the gap between short- and long-term interest rates narrows, it's a sure sign that the economy is softening.

And if short-term interest rates actually rise above long-term rates - not impossible, the way things are going in both markets - don't be surprised if this softness becomes a recession.
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