When most of us think about “the market,” stocks – Apple (O:AAPL), Microsoft (O:MSFT), Johnson & Johnson (N:JNJ), General Electric Company (N:GE) – are front of mind.
This “market” – equities – is valued at approximately $26 trillion.
But, as Wall Street Daily’s Chief Income Analyst Alan Gula notes in today’s Saturday Spotlight, equities are but a portion of a much broader financial market.
Indeed, the total value of the U.S. bond market – comprising publicly traded debt securities issued by the federal government, mortgage-backed securities (MBS), corporate debt, municipal bonds as well as money market instruments such as Treasury bills and commercial paper – is approaching $40 trillion.
In other words, the bond market is more than one-and-a-half times bigger than the stock market.
Sure, Alan’s talk today tends a little to the technical. It’s worth the effort, because all that data has meaning.
Stocks vs. Bonds
Of course gyrations in the stock market have consequences. However, the impact of major equity market moves is more often felt by John Q. Stockjobber, whose annual bonus and conspicuous consumption may vary with those up and down moves.
Take Black Monday – October 19, 1987, a date etched in the memories of many pros still active on Wall Street – when the Dow Jones Industrial Average declined by 22.61%.
The broader economy was barely affected. Economic growth actually increased throughout 1987 and 1988, and the DJIA regained its pre-crash closing high in early 1989.
Of more recent vintage, the May 6, 2010 flash crash – also known as “The Crash of 2:45” – was a trillion-dollar wipeout that started at 2:32 PM ET and lasted for 36 minutes.
The algorithm-based trading techniques such as “spoofing,” “layering,” and “front-running” that the Commodity Futures Trading Commission blamed for the Flash Crash are now banned.
But the U.S. stock market continued its post-March 2009 rally in short order, as did the economic recovery from the Great Recession – although it was and is jagged, sluggish, and unsatisfying.
The same responses followed the August 24, 2015 flash crash.
A serious malfunction in the bond market reverberates throughout the real economy for years. And its impact can be immediate.
If GE, for example, can’t issue commercial paper via money markets, payrolls aren’t met.
The longer-term effects of the most recent credit crunch are visible all around us, still.
Writing in the Journal of Economic Perspectives, Arvind Krishnamurthy, Harold Stuart Professor of Finance at Northwestern University’s Kellogg School of Finance, opened a winter 2010 essay with the observation, “The financial crisis that began in 2007 is especially a crisis in debt markets.”
Note the present tense. It’s pretty instructive.
The Meaning of “Is”
The Federal Reserve Bank of St. Louis has a complete timeline of this global event now commonly referred to as “The Financial Crisis.”
It begins on February 27, 2007, with the announcement by the Federal Home Loan Mortgage Corporation, or Freddie Mac, that it would no longer buy the most risky subprime mortgages and mortgage-related securities.
It ends on April 13, 2011, with the release by the U.S. Senate Permanent Subcommittee on Investigations of its final report on its inquiry into key causes of the crisis.
Although the most intense aspects have certainly eased, there’s no question we’re still experiencing the destabilizing effects of what happened from early 2007 through early 2009.
The European Central Bank just cut the overnight lending rate to encourage lending, and it extended its bond-buying program.
“What is quantitative easing?” asks a headline posted to the Business section of the BBC News website on December 3, 2015.
This question prevails seven years after the term went viral when the U.S. Federal Reserve started buying $600 billion of MBS per month in an effort to ease pressure on financial markets, with risk-free, short-term interest rates already at or near zero.
Japan is now experiencing a quadruple-dip recession.
And the Fed is only now on the verge of the first increase in the federal funds rate since June 2006.
(Even a December hike is questionable now, with the Institute of Supply Management Manufacturing Index for November dropping to 48.6 – the lowest level since June 2000 – from 50.1 in October.
A reading below 50 indicates more companies are contracting their business than are expanding operations. It’s also interpreted as a shorthand indicator of economic recession.)
Ground Zero
The most important central bank in the world remains at the “zero bound,” tethered to extraordinary monetary policy made possible by events nearly nine years in the past.
The first of those events – the epicenter, if you will, of the Financial Crisis – is found in MBS, the second-largest subsector in the bond market, trailing only U.S. Treasuries in value outstanding.
Freddie Mac’s announcement that it no longer would purchase riskier MBS securities was the first major sign of serious trouble within the subprime mortgage market.
Homeowners were levering up, assuming ever-rising home prices could support increasingly lavish lifestyles. American homes were essentially ATMs. This was an era characterized too by NINJA loans – credit extended to borrowers with “no income, no job, and no assets.”
Thus, as Dr. Krishnamurthy concludes, “A full understanding of what happened in the financial crisis requires inquiring into the plumbing of debt markets.”
Consider today’s Saturday Spotlight an introduction to this plumbing. The ongoing inquiry – including solutions – is found in The Shockproof Investor.
In this month’s issue, for example, Alan’s deep dive explores a “once-in-a-decade” warning emanating from the corporate bond market.
At the very least, we should be preparing for a bear market in the S&P 500 in 2016.
Alan Gula is not going to predict exactly what will catalyze it, exactly when it will start, and exactly how it will play out.
But if your money is important to you, you need to know how to prepare.