How Stocks and Bonds Are Related: Investor Step Toward Market Mastery

By: Money_Morning

Shah Gilani writes: Over the past couple of months, I've been sharing with you some tips about how new investors can break into the market. And I think it's the perfect time for our next lesson - looking this time at the inextricable connection between stocks and bonds.

Although I tend to write about the stock market as if it were a singular entity, I'm usually talking about the markets in the plural. Not just the Dow Jones Industrial Average, or the S&P 500 Index, or the Nasdaq - when I'm talking about the stock market or stocks, I am talking about ALL the indexes.

But when I use the word markets, I'm talking about not just the stock market indexes but also the entire bond market.

Stocks and bondsThe bond market isn't just the U.S. Treasury bond market. The bond market is to me, and should be for you, all the different bond markets, including but not limited to Treasurys, corporates, sovereign bonds, and junk bonds.

The word markets encompasses stocks and bonds because they are inseparable. There is an immutable relationship between stocks and bonds. They are connected at the hip. From now on, you, too, should always think of markets as both the stock market and the bond market.

It's OK to only think about stocks when you're making stock trades, analyzing your stock positions, or just chatting about the stock market. But always keep the bond market in the back of your mind when you're thinking about stocks. Remember the bond market when you're listening to pundits talking about stocks and when you're reading about stocks or the stock market.

And now I'll tell you why you almost always have to think of stocks and bonds together.

Stocks and Bonds: Mirror Images

And now, here's the reason stocks and bonds are so connected:

It has to do with interest rates.

First and foremost, they are substitutes for each other. You can buy a stock and hope it will rise in price, or buy a stock for its dividend yield and hope it rises in price, too. Or you can take that money and buy a Treasury bond, a corporate bond, a junk bond, any bond. The investment you make is your choice.

But there's more to it than stocks and bonds being alternatives. They are connected because bonds - which are really "interest rates" - are part of any stock valuation equation.

For example, there's margin. People buy stocks on margin. They borrow money to buy more shares with their capital. That's called leverage. Margin has a cost - you have to pay interest on the money you borrow to buy more stocks. If interest rates rise, you may have to pay more to borrow. You, especially if you're a big hedge fund with a lot of leverage, have to calculate the cost of "carrying" your positions.

If interest rates rise, not only might bonds become more attractive on a relative basis, not only will margin and leverage considerations come into play, but the companies whose stocks you're buying or hold are affected by rising rates, too. You have to consider what their cost of money is, how much do they borrow, or have to borrow, or how rising rates will affect their products and services and the customers for their products.

Interest rates, and whether they're rising or falling or flat, have a lot to do with how stocks are thought of.

Think about it: In what ways do you think rising and falling interest rates affect stocks?

Keep thinking. There are more.

Now, think about what rising and falling interest rates might do to bonds.

Stocks and bonds generally move in relationship to each other depending on what the nature of those relationships are. For the most part, investors know what they are and understand them.

But sometimes, like right now, some of those relationships diverge from their expected paths. Divergence can be telling or indicative of a change in trends or a future trend.

Think about the relationships, as many as you can, between stocks and interest rates and bonds.

In my next column, we'll get into "divergences" - what they can mean, how they can be directional indicators, and how to interpret the smoke signals on the horizon.

Source : http://moneymorning.com/2014/05/29/how-stocks-and-bonds-are-related-a-step-toward-market-mastery/

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