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Stocks and Bonds Go Down Together

by J. Orlin Grabbe

Like Jack and Jill going down the hill, stocks and bonds go down together. This is surprising only to people incapable of comprehending the most elementary principles of finance--their understanding polluted, perhaps, by having watched too much CNBC, or by having taken a course in macroeconomics.

Restated, when the stock market collapses, interest rates go up. At this very moment there is a worldwide crisis in bond markets around the world. Why? Because stock markets have been crashing, and interest rates have been going up. Yet many stare at this phenomenon blankly, uncomprehendingly, and then turn their attention back to this hour's financial guest guru on TV, who is distinguished from last hour's financial guest guru only by the color of his tie: "If there is to be stock market weakness, you should think of moving part of your portfolio into bonds."

And the suckers just keep phoning in. Get out of the bad rainbow stock stew, they are told. Get into the good rainbow bond stew. That way free lunches and free bubble-up will continue for everyone forever.

Let's take a very simple example. A software company which has some existing assets. For simplicity, let's get rid of future earnings and all those complicating factors.

The company has $150 of pre-sold software. It has already produced the software. It has contracts saying it will be paid $150 for it. That's the company's assets.

The company financed itself by issuing $100 worth of bonds. It pays no interest on these bonds. Rather, the bond principal will be returned to bondholders when payments for the pre-sold software come in. The bondholders thus have a claim on $100 of company assets.

The company has stockholders. The stockholders own the company. When the money comes in, the stockholders will repay the bondholders the $100 they owe them, and keep the remaining $50 for themselves. So the stock has a value of $50. Restated, the stockholders have a call option on the value of the company's assets.

The stock represents a call option, because as long as the value of company assets is greater than the $100 owed to the bondholders, the stockholders will exercise their call option at its strike price of $100 in order to buy (retain ownership of) the company assets at that price. The stockholders will do this because the call is in-the-money. Exercising the call (i.e. paying off the bondholders) only requires $100, but the value of the underlying company assets is $150.

So here is the company's balance sheet:

Assets
Liabilities
$150 pre-sold software$100 in bonds
Equity
$50 value of stock

Bonds are a direct claim on the value of company assets. Stock is a call option on the value of company assets. Do you begin to see why bonds and stock values might decline together, if the value of the company's assets falls?

Suppose that, because of a declining economy, people begin to renege on their sales contracts. Sure, they've agreed to pay for software, but all the lawyers in hell can't get blood out of a turnip. As a consequence, the company's management make their best determination that only $110 of their sales are collectible.

The stock is now only $10 in the money, and its value has fallen accordingly. The company's balance sheet now looks like this:

Assets
Liabilities
$110 collectible sales$100 in bonds
Equity
$10 value of stock

Meanwhile, the bondholders, who have been monitoring the company because they have a stake in it, say to themselves: "Hmm. The company theoretically still has enough collectibles to pay back the $100. But suppose management is wrong? Let's get out of these bonds, and dump them on some other suckers."

But news of the company's problems has leaked out. So when the bondholders go to sell their bonds in the secondary market, the purchasers say to themselves: "The economy is deteriorating. Maybe the amount of collectible sales is even worse than everyone thinks. We had better allow for more margin of error. We will only pay $90 for the bonds."

So, if the bond trade takes place, it takes place at $90. Since the bonds have a face value of $100, the implied interest rate on the bonds (ignoring any adjustment for time factors) is:

$100/$90 - 1 = .1111 or 11.11%.

Interest rates have gone from zero to 11.11%, while the stock value has declined from $50 to $10 (that is, to 20 percent of its previous value).

We will call the bonds issued by this company, Software bonds.

"Yes," you say. "All this may be true of Software bonds. But what about Mafia bonds?"

Mafia Bonds

The Mafia provides protection services. The Mafia's goons roam throughout the neighborhood demanding "protection payments" from each of the area's residents. If some individual declines to pay, the Mafia's goons beat him about the head and shoulders with sticks, and also on the shins and kneecaps, until he voluntarily agrees to pay the required amount. Otherwise, the goons simply carry off the individual's assets back to Mafia headquarters. In either case, the Mafia gets the requested payment.

The Mafia goons who collect protection payments are known as the Icon Restoration Society (IRS). They view their work in religious terms.

Since nearly all goons are employed by the Mafia, the Mafia has little work to do with respect to its protective services. And the Mafia likes to make its bondholders happy. Consequently, Mafia bonds offer a healthy 5% interest. Here is the Mafia's balance sheet:

Assets
Liabilities
$105 protection services$100 in bond principal
$5 in bond interest
Equity
$0 book value of goons

So, as the economy deteriorates, financial gurus appear on TV and say, "Sell your stocks and buy bonds. But do not buy bonds issued by risky software companies. No. No. Instead buy Mafia bonds! Mafia bonds are default-free, because the Mafia's goon army assures the Mafia's sound credit!"

"What about the deteriorating economy?" one caller asks the TV guru.

"Yes, things are getting worse for everyone. The Mafia goons may have to apply a few more strokes with their sticks. But, we know from history, they always collect their payments! Mafia bonds are sound investments.

"That's why we have now made it mandatory that all retirement funds be invested in Mafia bonds. We want to protect retired people. You can always count on Mafia bonds, even when times are bad!"

Some people, hearing these words, rush out to dump their Software bonds and buy Mafia bonds. This further depresses the price of Software bonds in the secondary market, increasing their interest yield to 13%, while driving up the price of Mafia bonds, decreasing their interest yield from 5% to 4%.

"Aha," you say. "See. Because of the deteriorating economy, stocks have gone down, while interest rates have fallen from 5% to 4%. See, you were wrong. And I will live and retire to drink the free bubble-up and eat the free rainbow stew after all."

Meanwhile, however, over at the University, trouble is brewing because of the Heretic, Dr. Painexpose.

The Mafia Theory of Economics

Dr. Painexpose is angry. "The system is a gigantic fraud," he says. "The Mafia doesn't produce anything. Yet people rush to buy Mafia bonds when the economy deteriorates. This pulls capital out of productive enterprises like Software, and Machines, and Wheat-Growing, while increasing the resources available to the despicable Mafia, which produces nothing."

"Don't listen to him. He is a heretic," the other professors say. "He doesn't teach the Mafia Theory of Economics like we have always taught it, and like we bequeathed to him."

"He is just an anti-Mafia rabble-rouser," some say. "He is in the secret employ of the Software companies," others assert.

The chancellor of the University receives a phone call: "We regret to say that there will be a hold-up in this year's Mafia grant for the promotion of the teaching of the True and Verifiable Principles of Bond Economics. We hope to have this straightened out as soon as possible."

But Dr. Painexpose is undeterred. "Making retirement funds buy Mafia bonds is a joke. By diverting capital into unproductive goon activities, you are assuring that the economy of the future will be in even worse shape than it is now. So you are not increasing the economic security of retirees. You are in fact decreasing their security. The date at which we run out of free bubble-up and free rainbow stew is now closer than ever!"

"All the Mafia goons in hell," Dr. Painexpose further declares, "can't get blood from a turnip."

"Dr. Painexpose is a fear-monger," the newspapers say. "Your bubble-up is secure," declares Stanley Ichthyophagist, Chairman of the Department of Mafia Economics. "By our careful calculations, and subtranscendental logarithms, we have determined that there will be free bubble-up forever. The thirsty can relax."

"Dr. Painexpose hates old people and wants to steal their retirement funds," declares Mike McCorleone, Mafia spokesman. "But what we wonder is what defect of Dr. Painexpose's psychology would lead him to make such statements, to have such extreme views of the world. Was it something in his childhood? We fervently hope that Dr. Painexpose is not depressed or suicidal."

Soon thereafter, Dr. Painexpose is found crucified upside down, hanging from a rock face in New York's Central Park. The Park Police quickly rule the death a suicide.

"He obviously wanted to be a martyr," a Park Police spokesperson explained.

Meanwhile, the economy continues to deteriorate. Collections by the IRS become ever more difficult and forcible asset extractions ever more public. The newspapers interview one man who was beaten to a bloody pulp outside his front door.

"Well, I couldn't help reflecting, as the IRS jerked my last piece of furniture out of my hands, stepping on my wrist and smashing a rod across my kidneys--even in my pain, I couldn't help thinking: At least my retirement is secure. After all, it's all invested in Mafia bonds."

Data

The New York Times, the newspaper of record, which prints all the news that's fit to print, declared on September 17:

"Toting up the dollars lost by investors in bonds in August is difficult because of the market's opaqueness: $48 billion was lost in emerging market debt that was denominated in dollars, $14.6 billion disappeared from portfolios of convertible bonds, another $15 billion was likely lost in junk bonds and $1.67 billion disappeared during the month from an index of real estate investment trusts that invest in mortgage securities. That's about $80 billion lost." (September 17, 1998)

Let's see. Bonds went down in August. Stocks must have gone up, right? One or the other, else the rainbow stew isn't secure. Maybe it's time to get out of bonds?

"Dealers at major Wall Street brokerage firms are no longer bidding for bonds from their customers; they will only take an order if they know they have another customer interested in owning the bonds. And since few investors are interested in adding to their bond positions until they see the market stabilize, most sell orders don't get executed."

If you want to know the "cause" of all this stock, bond, and economic trouble, I would direct you to my article "The Collapse of the New World Order," coming next month in Liberty magazine.

But, for the next year or so, avoid stocks, bonds, and gold. We are in a global deflation. Cash is king. But only cash that preserves its value. Sound banks. US Treasury bills are fine for now. The dollar appears to be peaking. The Swiss franc may, for the first time in years, be a good investment.

But as for the free bubble-up and the rainbow stew, don't you believe it.

-30-

This article appeared in Laissez Faire City Times, Vol 2, No. 30.

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