Forecasting market direction is the holy grail of investing but it is virtually impossible to accomplish.
Because the market is made up of hundreds of millions of trading investors at any given time, one would have to know the cumulative decisions of all of them and then know what effect that would have on a particular stock or index. Much like the impossibility of forecasting the twists and turns of a million flying Swallows, the best man can do is base his forecasting on what the markets have done in the past, which leads to the popular disclaimer “past market performance is no guaranteed of future results”.
Although anything can happen in markets, knowing what usually happens in the front of big events may be helpful in preparing for major upsets or giddy upswings.
It is generally accepted that stocks and bonds can move opposite of each other. Bonds are simply IOU’s for money borrowed.
The reason for the contrary movements in bonds versus stocks is because bond vehicles, whether they be individual issues or baskets (like a bond fund) can offer a fixed rate of return much like a savings account or C.D. Because investors buy these products for the fixed rate return, the price of bonds generally don’t move as much as stocks do.
Bonds fall into the class of fixed income which also can include preferred stocks, mortgage products and other investments that pay a fixed interest rate.
The mindset adopted by investors when purchasing bonds is widely acknowledged. Investors expect bonds and stocks to move contrary to each other. When markets are in rally mode, investors may shed bonds in favor of stocks, hoping stocks rise in price faster than the fixed rate fixed income investments offer. When markets fall, investor tend to sell stocks in favor of bonds.
This opposite movement of stocks and bonds is the reason investors and their advisors allocate a portion of portfolio funds to each. The percentages of how much to hold in each varies depending upon the investor and any mix of bonds and stocks is possible. The desired result may be partial protection no matter which way markets may turn.
Where problems can arise is, in my opinion, is when the markets sell off and continue to do so in a prolonged event.
I visualize a series of events that may indicate there is more to the sell off than meets the eye. In other words, there are canaries in the coal mine of the markets if you know where to look.
For example, if the market sells off for a day or so, bonds might rise, exhibiting the desired offsetting effect on portfolio balances. Should the market continue to sell off however, the depressed mood of investors can start to bleed over to the fixed income market, meaning bonds and similar investments may stop rising, flat line, then even start to join the downward direction of the overall market.
When looking at market routs, I tend to watch the bond market as to investment sentiment.
Often if stocks keep falling, investors may start to sell off bonds to raise cash for margin requirements, which is a credit line some investors use to buy more stocks than they have money for.
Additionally, since bonds are just IOU’s from a borrower, falling markets can cause cash shortages, making the possibility of a bond default (the borrower is unable to pay the bond interest or principal) because money is being lost in the markets.
Although there are many events that can indicate increasing stress in financial markets and experienced analysts should know what to look for, novice investors and advisors might simply keep an eye on the fixed income markets of which bonds are a big part of.
Should they begin to reverse and follow the markets down, it may indicate more is afoot then just a normal and healthy correction.
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