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Cramer: The Power of Bonds and the Fed on Stocks

Text copyright © 2013 by J.J. Cramer & Co. From JIM CRAMER'S GET RICH CAREFULLY, reprinted with permission from Blue Rider Press, a member of Penguin Group (USA) LLC

We've covered the impact of supply and demand on stock movement, the power of the S&P to play a role in a stock's performance and the incredi­ble sway of sectors to move as a stock in lockstep with its cohort, whether that's right or not, which we now know it isn't.

Before we get to what you think probably causes the lion's share of the movement, the now rendered quaint impact of the company's fundamen­tals on the stock, at least on a short-term basis, let's consider a few more extraneous factors influencing stocks. These have grown far more impor­tant in the past few years than at any other time in history and will only gain in importance going forward.

Let's start with the bond market. I know the mere mention of the word "bond" drives you up a wall. Bonds are incredibly boring even to me, and I am a financial junkie. I don't even want to hazard a guess about what you might be thinking about them. But when it comes to the stock market, they can have a really powerful, often unseen impact. Bonds act like bullies toward stocks; they are always behind the scenes, throwing their considerable weight around-the bond market is much larger than the stock market in actual dollar size-distorting prices all over the place in a pretty significant way. These days, if you don't know about the im­pact of this colossal "fixed income" asset class, as it is called, on your com­mon stocks, then you are now investing imprudently and taking far more risk than you realize. Let's fix that now. You are not reading "Get Rich Recklessly."

Remember to always think about your common stocks within the broader context of all the investments there are to choose from. Imagine that stocks are just another form of goods, some sort of merchandise that gets sold in an aisle in the vast financial supermarket. The bond market section of that supermarket dwarfs the stock market section, where aisle after aisle is filled with treasury bonds, corporate bonds, mortgage bonds, convertible bonds, municipal bonds and all sorts of other esoteric instru­ments. The commonality in the bond section? They offer a "fixed income" return-paying you a regular interest stream-backed up by the issuing entity, whether that is an individual corporation, a municipality or the federal government. The last is, by far, the largest issuer, which stands to reason given the size of our nation's deficit.

The competition for your dollars is steep. Stocks, we know, offer lots of upside, but they offer lots of downside too, making them riskier investments than bonds, but ones that carry bigger rewards. Bonds can also be volatile. They can gyrate up and down in price, especially of late, as the Federal Reserve tries to extricate itself from buying bonds on a reg­ular basis to depress interest rates to increase business, especially home building, and decrease unemployment. But bonds do have a guaranteed element that stocks don't have that is tremendously appealing to any in­vestor. When you buy a stock it may not offer much income, if any at all, after inflation, and you can't return it to the supermarket for the full price once you've checked out at the register. But bonds give you a fixed income stream and a money-back guarantee on top of it.

If that confuses you, think about it like this: if you have a mortgage, you are in the same situation as a bond issuer. You borrow money, you pay interest on that money and then you pay back the initial principal when you are finished with your loan. However, if you don't pay back the loan, the bank can and will-as we know from crises past-take possession of your home. When you consider that guarantee, wouldn't you rather be on the other side of your mortgage? That's how bondholders feel. They love the surety and protection bonds give them because they get a regular in­come stream over the life of the bond, and then they get their money back, guaranteed.

Corporate bond holders, for example, can take over the issuing enter­prise if they are stiffed, because bonds are often backed up by the assets of that enterprise. When corporations file for bankruptcy, corporate bond holders seize the assets and sell them to make themselves whole. Investors who purchase mortgage bonds-bonds backed up by the principal and income stream of a basket of mortgages-can seize and sell the houses that make up the basket if the bond defaults. The lion's share of the fore­closed homes caused by the Great Recession are houses that were seized and sold by mortgage bond holders. Even municipal bond owners can at least try to seize the assets of the municipality if it has any worth seizing, as the municipal bond holders in Detroit are discovering.

The only bondholders who can't seize the enterprise are owners of government debt. The federal government, rather than allow itself to be taken over by its lenders, gives bondholders what's known as a "full faith and credit guarantee" that they will get their money back. Yes, coun­tries can default. It's been known to happen. The mere whisper of a poten­tial default by the U.S. government on its trillions of dollars in debt can cause huge turmoil in all assets, even in stocks, as we found during the debt crisis in 2011, when stocks declined almost 20 percent, in part because of fears that the U.S. government debt would be downgraded by the agencies that rate debt: Standard & Poor's and Moody's. Ultimately the S&P did take U.S. government bonds down a notch because of the runaway deficit, but actions taken to try to control government spending salved the agencies, and worries about the integrity of the debt and its issuer died down. We saw this pressure again in the government shut­down and debt ceiling fracas in 2013, when the government again almost defaulted. That's why, although it sounds glib, we regard treasuries as "risk-free" assets. The federal government's promise to pay is considered inviolate among debt holders, and even in the darkest of moments of the financial crisis, that promise has not been in question by most treasury debt holders.

 

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