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.
At various times bonds can give you a higher yield than stocks, and historically they have. However, because of the hideous rise in unemployment that the Great Recession engendered, the Federal Reserve, as just mentioned, has tried to keep bond rates lower than normal by buying huge amounts of bonds in order to jump-start the economy. Makes sense. The Fed's trying to influence the whole financial system with its interest-depressing bond buying, so you can get a low-interest mortgage or refinance your mortgage at a lower rate, or a corporation can borrow for less or can issue bonds with lower coupons-the income stream-to expand or pay down the higher-cost debt. The Fed has wanted everyone to take advantage of its largesse. And, to some degree, that has worked, as housing prices have rebounded and jobs are more plentiful than they've been since the Great Recession started. It has also led to a rise in stock prices from a multitude of directions. Companies, for example, have been able to borrow money cheaply to go into the stock market and buy back their own shares, driving up stock prices. They've borrowed low-cost money to pay out higher dividends. They've paid less in interest charges, which leaves bigger profits for shareholders. It has been a very virtuous circle that has had an immensely positive impact on stocks, which is why we have often had to hang on every word from the Fed, fearful that it might be bringing this halcyon period to a close.
Let's go back to the financial asset supermarket so I can show you the impact treasury bonds have on the entire bond and stock food chain. All fixed-income assets are priced "off of" treasuries, meaning that any other bond issuer is going to have to pay more in interest than the Treasury because its bonds can't be backed up by the full faith and credit of the government after the wrangling of 2013, although the better the balance sheet, the lower the interest rate the company might have to pay to bondholders. You may scoff at our government, but bondholders know that explicit guarantee is still the safest guarantee, worth more than any other promise to pay by any other entity. Because of the risk-free nature of federal government debt, the yield on government bonds is going to be lower than any other issuer's debt at any period in time: six months, one year, ten years, thirty years, it doesn't matter. So if the Fed keeps rates down on treasuries, every issuer gets to issue debt at lower rates than it might otherwise.
It would be terrific if all of this bond market interaction could be kept within the fixed-income section of the supermarket, but it's too big and too powerful to be contained. We recognize that stocks have flourished ever since the Great Recession because the Fed has kept all interest rates artificially lower by buying hundreds of billions of dollars of U.S. government debt. That has made bonds less competitive with stocks, particularly stocks that offer yields that are higher and therefore more attractive than you can get from fixed-income alternatives. But as the economy gets better, the Federal Reserve can let the interest rates return to more natural, higher levels. That's where the competition sets in. As interest rates on debt go higher, supermarket shoppers seeking income are more attracted to the bond section and less interested in the stock aisle. Why take the risk that a company might cut its dividend when times get hard again? Why not just go buy a less risky bond with a guaranteed income stream? Not only that, but stocks have had a big run. The collective yields on stocks have come down as stocks have rallied because the yield is simply an arithmetic equation: the size of the dividend divided by the price of the common stock. A $20 stock that yields 5 percent because the company pays out a $1 dividend yields only 2.5 percent if the stock goes to $40.
Sure, that's terrific if you owned the stock while it ran up and you got the dividend. But imagine you are a new shopper. You walk into the financial supermarket, peer down the stock aisle and see a piece of merchandise that has doubled recently and pays only a 2.5 percent yield. Then you walk down to the fixed-income section and see bonds backed up by the full faith and credit of the United States that now yield more than that stock. You're likely to be tempted to buy the bond rather than the stock because the bond is less risky. Other shoppers want to cash out of that stock entirely and put the proceeds in bonds.
The pressure from bonds as competition for stocks has heated up so much that now bonds are far more important than at any time in recent history. The higher the interest rates on bonds, the more pressure you will see on stocks, particularly stocks that had become "fixed-income equivalents," meaning that they were being used by savers instead of bonds to get a good income. For example, many investors seeking decent yields rotated into the stocks of consistent utilities, like Con Edison, American Electric Power, or Southern Company. For a time they were able to get double the interest rate they could on treasuries. The switch made economic sense even though utilities, as safe as they are, certainly aren't risk-free. However, with bonds now yielding similar to utility stocks after the increase in interest rates, these stocks simply aren't as attractive, especially given their price increases, so they, too, get sold down when interest rates tick higher. This switch from once higher-yielding stocks into now higher-yielding bonds takes place every day, and it puts pressure on the market regularly. The competitive threat from bonds is now fearsome and is a huge influence on stocks pretty much on a daily basis. As long as you recognize this, you can use it to your advantage because (1) you now know what might be behind the selling of a lot of the higher-yielding companies you own, and (2) you too might want to take profits on those stocks because they simply aren't as attractive as before, given their run-up and the better, less risky returns that bonds offer. Of course, as always, I urge you to consider each stock on a case-by-case basis. The themes and methods I will trace out in this book can transcend this impact and allow you to profit from it, but not if you don't understand why it is happening and how it has led to a dramatic and rapid change in how stocks are being viewed and bought and sold.
None of this bond and stock interplay that the Fed has stirred up is new; it's just more salient because rates are coming off all-time lows. That whole supermarket section has come alive with competitive activity, and it's pretty darned distracting and compelling to all investors.
However, as part of being a more prudent investor than in the old days, we now also have to consider the traditional influence of the Fed on the economy in general because we've enjoyed such a prolonged period during which the Fed has been friendly to stocks. That's not going to last as long as the economy keeps percolating and the Fed starts worrying about the need to curb inflation. Remember, the Fed has two mandates. We've been living with the first mandate: getting the economy moving when it is slow, so more jobs and wealth are created. Now, though, the second mandate, the cooling of an economy that's gotten too hot because of low rates, is coming into play, and careful investors must adjust accordingly. I always say, "Never fight the Fed." If the Fed is keeping rates low to get the economy moving, there are tons of opportunity in stocks. But when the Fed is exercising its second mandate, raising rates to fight inflation, the options narrow accordingly. We've got to recognize that new and negative reality if we are going to be prudent about our investment choices.
We've already discussed the supermarket impact of the interest rate rise. We understand the instant attraction of bonds that comes from the sudden jump in rates after years of declines. We recognize the competitive threat they now offer, especially when we consider the reduced yield stocks give you because of the terrific rally we've had from the stock market's bottom in 2009.
But as the second mandate of the Fed, the need to slow down the economy to prevent inflation, comes into play, we have to be concerned about the impact higher rates have on the companies themselves, not just the yields on their stock prices relative to the yields on fixed-income alternatives. The Fed's moves have always had a real impact on the pace of economic growth, which then affects the sales and profits of the companies we invest in. The Fed has been trying to keep interest rates low and steady to quicken that pace, but when it moves to cool the economy and prevent inflation from raging, that's a different story. When the Fed raises rates, money managers who control trillions of dollars in assets tend to flee from stocks en masse, particularly those of economically sensitive enterprises, because they know that earnings estimates might have to come down as a consequence of the Fed's actions. Most companies simply can't make as much money in a rising interest rate environment. Many have to borrow money to do business on a regular basis, and when the cost of that money goes up, it has a real impact. A retailer may have to pay more to finance its inventory. Customers may have to pay more for credit to buy goods. There is a repercussion to higher rates that causes analysts who follow stocks to automatically want to cut earnings estimates. There is also a mitigating factor, however. If the economy is recovering, some companies may be making more money and the increase in rates won't matter as much. Why cut earnings estimates because of interest costs if sales are so much better because of a stronger economy? Can't a housing company that is hurt by higher interest rates sell more homes because the economy is better and more people have jobs and will look to buy houses? It's a real tug-of-war across many industries as analysts set out to determine which companies might be doing so much better from a stronger economy that higher rates don't matter.
Still, though, the overall implication of higher rates is not a positive for the stock market; it's a negative, regardless of the improvement in earnings companies might experience from a stronger economy. So with every rate increase, you get selling in stocks and, more important, stock futures. Given the lockstep nature of the S&P futures and stocks that I described earlier, you get that uniform impact on all stocks when institutions move quickly through the futures to reduce their exposure to equities. As usual, I don't want to just describe these actions. You will get plenty of that from others. I want to tell you how you can prudently profit from this bond market pressure on all stocks. For example, when stock index futures plummet because of worries about the impact of higher rates on corporate profits taking down all stocks, that could be a terrific opportunity to buy the stocks of companies that aren't all that sensitive to rate increases. You want to be looking to buy the stocks of companies that aren't hurt all that much by the slowing of economic activity the Fed is bringing about, meaning that they are not as cyclical or beholden to the economic cycle that the Federal Reserve is trying to slow down. That's the time to pick up growth stocks like Celgene, Regeneron, Amazon and Netflix, whose earnings streams are not dependent upon the economy continuing to prosper. It might be the time to trim the stocks of companies that need rates to stay low and economic activity to increase in order to beat the estimates Wall Street is expecting, stocks like Alcoa or Freeport-McMoRan Copper. Most important, these interest rate-induced sell-offs are precisely the time to fall back on the stocks that benefit from the major themes I am going to tell you about in a coming chapter, themes that are much bigger and can transcend the entire interest rate discussion. Still, though, the careful investor must feel comfortable with the role of the Fed because the Fed may not be as friendly as it was. And just as we don't fight the Fed when it is trying to help us make money and get the economy moving, we don't want to be oblivious to the Fed when it is no longer as friendly to our attempts to build great wealth by buying the best stocks in this new environment.
Let me give you a simple example of how this interplay can impact your stocks, so you can profit from the turmoil it produces. Let's use the stock of Bristol-Myers Squibb, because everybody knows the company as a high-quality maker of pharmaceuticals that isn't beholden to the economic cycle at all. Its growth is considered secular, not cyclical, meaning that its prospects are influenced by long-term trends like the aging of the population or the increasing ability of the middle class worldwide to obtain life-saving drugs. Neither of these secular trends is impacted by the Fed and its attempt to control the pace of U.S. economic activity. Yet the stock of Bristol-Myers will get tossed down like all others in the S&P 500 when institutions sell S&P futures because they fear the impact of higher rates on economic growth. Yep, even though Bristol-Myers can thrive in this environment, its stock gets pummeled initially, like all others, as if its earnings were going to be depressed by the Fed's actions. So you might want to bid for that stock below the last sale price when this interplay is triggered so you can buy it more cheaply than you would otherwise expect, if you believe interest rates will stabilize or peak in the near future. It's the natural way to profit from the unseen forces I have traced out.
Now, though, as with everything else in the past few years, things are not as easy as they used to be. We have to recognize that the supermarket impact I talked about earlier also comes into play with a higher-yielding stock like Bristol-Myers or any of the older pharmaceutical companies. The careful investor simply must take into account this complex competitive yield issue, because many investors in the past half-dozen years have sought the relative safety and higher yield of the stock of Bristol-Myers as an alternative to low-yielding bonds, not just because of its terrific earnings prospects. That means if interest rates keep rising, you have to recognize there could be extra selling pressure on a stock like Bristol-Myers not just because all stocks are coming down but because investors in higher-yielding stocks might be dumping them to take profits and go back into less risky bonds. These "fixed-income alternatives" don't hold up all that well when rates go up because those investors who used them as alternatives to bonds aren't all that interested in the characteristics and fundamentals of the individual companies that paid the dividends. In fact, some investors might not even care about how the company that is Bristol-Myers is doing. They may not know, for example, that Bristol-Myers could be on the verge of a breakthrough cancer drug. They may not know that Bristol might be about to report an upside surprise. They may not even care if it is about to increase its dividend, something that bonds can't do. They just want to own something that gives them good income with safety, and they think that bonds, not stocks, give them a better opportunity now that interest rates have increased. To put it another way, while Bristol-Myers is a really good, safe company with a growing earnings stream that is secular in nature and not cyclical and beholden to economic growth that the Fed can squelch, its dividend is backed up only by its income stream, not the full faith and credit of the federal government. These fleeing investors care more about the yield and its guarantee than they do about the possible increase in Bristol's price that they might leave on the table. They seek capital preservation, not capital appreciation, and so they sell Bristol and buy treasuries or other bonds with more attractive, safer yields. It's just one more reason why, in this new, more treacherous environment, you have to disabuse yourself of the notion that what a company does and how it does should determine whether its stock goes up or down in value. I know, it's all rather counter-intuitive, but it is vital for the prudent investor to understand if she has any hope of using stocks to create bountiful wealth. The tug-of-war between a company's dividends and earnings prospects versus the band market's pull of interest income and safety may be a paramount concern for years to come.
How, you might ask, can you figure out when a run on the stock aisle into the fixed-income section of the supermarket might occur? How do you stay on top of this process so you can profit from it? I could say, "Just keep an eye on the stock market at all times." But I have a better way. I monitor the action by following the TLT, the iShares 20+ Year Treasury Bond ETF. This security goes down when interest rates go up, and vice versa. When the TLT goes down, you can expect the stock index futures to go down soon after, as stock index futures react to every minute move of this security. To put it in the new vernacular of the stock market, if you want to know what will happen to BMY over the extremely short term, just watch what happens with the TLT, because it's more in charge of Bristol-Myers stock right now than anything that happens inside that giant pharmaceutical concern.
I believe understanding bonds' gravitational pull on your stocks is integral to being an effective investor. Get used to it. You will see it as a theme for many years to come, as interest rates likely saw historic lows during the past few years and we won't be visiting them again, perhaps in our lifetime. The TLT will tell the tale. To give you some perspective on its newfound importance, I now have it at the top of my screen, right next to the S&P 500, above the Dow Jones Average.
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