How to interpret stock and bond prices

A quick guide to interpreting the markets, with an application to the news from the last week:

Finance 101: The fundamental value of an asset is the discounted value of future income flows from that asset. So when the stock market goes up, this indicates that investors expect more income sooner from these assets. Since these assets are claims on corporate profits, this means that they expect corporate profits to rise. Since corporate profits tend to rise during expansions and fall during contractions (recessions), a rise in expected corporate profits is good news for the economy. So the stock market going up is good news, and the stock market going down is bad news.

So what determines bond prices? Bonds are different than stocks in two respects. First, they are (generally) nominal assets, meaning that they are in the currency of a particular government. Secondly, they pay a fixed predetermined amount, unless the holder declares bankruptcy and defaults on them. Therefore they are in general much less risky.

The risk in bond prices is of two types. There is inflation risk -- if the currency in which they are denominated experiences inflation, they will lose value and yield a real return below their nominal yield. There is also default risk -- if the issuer runs into financial difficulty it may not repay.

Therefore a rise in bond yields (which is a fall in price) can mean three things. First, it can mean that inflation risk has gone up, and investors demand a higher nominal return. Secondly, it can mean that default risk has gone up, and so investors require a higher yield to compensate them for the risk that the issuer will not repay. Third, it can mean that the return from other investments has risen, and therefore investors require a higher return in order to accept bonds (this is arbitrage).

So how do we interpret stock and bond movements? Well, if we get good news about the economy, we should expect stock prices to go up. Since inflation tends to accompany expansion, both the inflation risk and rising returns on alternatives should raise bond yields. This shouldn't substantially affect default risk, so we should generally expect bond yields to go up too. If we get bad news, by the same logic we should see stock prices and bond yields fall.

On the other hand, suppose we find out that a country or firm is in bad fiscal shape for reasons apart from economic fundamentals. Then bond yields will rise because investors believe that a default is more likely, or that the country may run a higher inflation rate in order to reduce the real burden of its debt. Either of these should drive up bond yields, but since inflation or a default would likely hurt the economy, we should see stock prices fall.

In other words, when stock prices and bond yields move together, this is because of economic news (whether good or bad). When stock prices and bond yields move in opposite directions, this is a sign of fears of default or inflation apart from economic fundamentals.

Over the last week, the stock market plummeted. This was interpreted by some observers as a consequence of S&P's rating downgrade. However, the fact that bond yields fell as well, and especially that the US bond yield fell relative to other countries' bonds, indicates that what we saw in the last week was the result of bad news about economic prospects, not concerns about the safety of US debt.

If anything, all the signs indicate that investors really really want to hold our debt (the so-called 'flight to quality'). There's a school of thought that says that it is wise to make hay while the sun shines. If that's the case, there's no better time to borrow and spend than when the US government can borrow for 10 years at real interest rates below zero.