Because this topic is prone to much discussion (and disagreement), I will address it briefly for the sake of my own sanity and well-being.
Stocks are actually bonds in disguise
According to the survey, few people know what stocks are like Actual value – and there’s a simple test. If the current interest rate is 5%, can you write an exact formula to calculate the price of a 3% Treasury bond maturing in 18 years? If you can, then you know how stocks are priced; if not, you don’t. This is because stocks follow the same pricing formula as bonds.
Bond prices have been in a bear market for nearly two years, and we believe the stock market is about to be reminded why stocks are actually bonds in disguise.Warren Buffett explains this bond market charade Twenty years ago, in these short two minutes video.
If stocks are really a vague, undefined bond, as Buffett says, when will stocks start behaving like bonds?
Why stocks follow bonds lower
This five-year chart shows price changes in the S&P 500 Index compared to price changes in the 20-year Treasury note, represented by the iShares ETF TLT. It shows what we expect the stock market to do and why.
The green arrow shows we expect stocks to return to last October’s lows, and the black oval highlights why – long-term bond prices hit new lows as long-term interest rates hit new highs.
The stock market can ignore bond prices for the time being, but sooner or later the bond nature of stocks must emerge, and both work together. We think we’re in a “show and tell” moment right now.
To make it a little clearer – I think
While Buffett did mention interest rates when he mentioned “discount rate” in the video, he avoided going into detail about what happens to value when the discount rate changes in his calculations. The mathematical formula he was referring to was actually just the sum of a long list of similar fractions. These fractions are similar in that the annual cash flow (bond coupons or earnings) is the numerator and the risk-free rate is raised to the power in the denominator.
Ninety percent of the time investors only focus on the numerator (future cash flows). This is basically what most articles in SA do; look at the factors that might determine or modify a molecule. Only a few people pay attention to how the denominator changes.
However, at critical moments, the focus suddenly shifts and investors focus on the changing value of the denominator (interest rate) and its impact on all fractional values. We believe we are at a critical moment now.
While Sentiment King focuses almost exclusively on market sentiment and investor expectations indicators, we know its limitations and recognize when economic issues become dominant. We believe we have now achieved that.
The rise in long-term interest rates to new highs over the past two weeks has changed that. We believe most investors underestimate its importance. The current level of market sentiment allows for another sharp decline in the market, which we believe is now very likely. If it happens, though, it should happen quickly; the market won’t fall to last year’s lows.
low unemployment argument
An argument I hear a lot these days is, how could we possibly have a recession and another bear market with an unemployment rate of 3.5%? The problem with this argument is that it puts the cart before the horse.
The unemployment rate is classified as a lagging economic indicator; it is one of the last indicators to rise during a recession. Therefore, it cannot predict anything. However, the stock market and interest rates are two of the 10 leading economic indicators. They act ahead of the economy. This simply means that if the stock market and industrial production decline, then unemployment will rise. The chariot does not command the horse, and the chariot does not command the horse. It just follows where the horse goes.