Reader Curtis writes “Hello Mish: Can you explain why equities would also go down in a bond market selloff? Wouldn’t equities go up if everyone is dumping their bonds and buying REIT’s, commodities, etc.? They can’t all leave it all in cash.”
Curtis’ question came in response to Red Hot Junk and Massive Bond-Market Dislocations; Equity Smash Coming Up?
Three Base Fundamentals
It is impossible for people to dump bonds for stocks or dump stocks for bonds. For every buyer there is a seller. Someone must at all times hold every stock or bond issued. The exceptions are companies going private, bankrupt, or bought out. Bonds can be retired.
It is impossible for money to flow into stocks or bonds except at issuance (new bonds, an IPO, or secondary offering).
Sideline cash is a function of Fed printing and bank lending. It does not change when stocks or bonds are sold. So yes, it is impossible, in aggregate, for everyone to go to cash.
Equity Psychology
When interest rates rise it tends to slow housing, autos, and consumer purchases. Subprime auto and home sales are particularly sensitive.
When interest rates rise, so does interest expense on the balance sheet of corporations.
Many questionable corporations are in existence simply because they can borrow in the junk bond market. Guess what happens when they can no longer borrow to paper over money-losing operations.
Corporations have been borrowing money at cheap rates to buy back shares at extremely expensive prices. Those buybacks lowered the number of shares, boosting PEs. Yet PEs are still astronomical. When corporations can no longer borrow money for buybacks, or get scared about doing them, things start to reverse.
Although people cannot dump stocks, in aggregate, stock prices can fall dramatically simply on the psychology change. At some point, a light goes off and people start to realize the greater fools game is up.
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