This Is Not Your Father’s Stock Market

Do you know who Haruhiko Kuroda is? He’s the man who’s been selling happy pills to Wall Street for the past couple of weeks, causing the stock market to rally beyond its already precarious peaks. The influence of Japan’s central bank governor on trading in New York is just one of the reasons the market hasn’t been behaving in ways that conventional assumptions would predict. In fact, the boilerplate investing caveat that "past performance is no guarantee of future results" has never been truer. Here’s a rundown of what looks different now.

1. Cheap money doesn’t respect national borders. First, it was credit easing by the Federal Reserve, which purchased tens of billions of dollars of mortgage-backed securities every month in an unprecedented foray into the private financial markets. Now it’s the Bank of Japan pursuing its own easing policy, buying popular assets ranging from real estate investment trusts to exchange-traded funds. Before long, the European Central Bank may also get in on the act — if it ever gets serious about fighting the threat of deflation in the eurozone. All of these actions push money into the markets, keeping interest rates low so investors don’t have to look far for inexpensive places to borrow. Then they plow that money into stocks and bonds, pushing prices ever higher. It doesn’t matter where the money comes from, because there’s just one big global credit market. But when none of these three central banks are pumping the market with cash, the law of supply and demand suggests asset prices will fall again.

2. Stocks and bonds aren’t always moving in opposite directions. Traditionally, prices for stocks and bonds moved in opposite directions. Stocks have variable returns, but bonds pay a fixed percentage of their original value. If the return to stocks is expected to rise, investors ought to move out of bonds, lowering their prices, and vice versa. But that hasn’t been the case for a couple of years now.

Via FRED/research.stlouisfed.org 

One big reason why is that the overall demand for dollar-denominated assets doesn’t discriminate between stocks and bonds; when investors from around the world shift their funds into dollars, they buy both. What used to be a dynamic determined primarily by American investors switching between two asset classes is now the result of global investors switching between entire markets.

3. The stock market and the labor market may no be longer in sync. Historically, the stock market has been a leading indicator of the overall health of the American economy. It fell before employment shrank, and it rose before employment recovered. But the yearlong dip and lull that the market experienced starting in the summer of 2011 had no effect on the labor market. And now, as the stock market may be teetering, the labor market seems stronger than it has been in years.

Via FRED/research.stlouisfed.org 

Again, a big reason for this phenomenon is globalization. The companies that make up the Standard & Poor’s 500 index receive close to half of their revenues from outside the United States. Imagine that one such company finds that it can make its products much more cheaply overseas. That’s good for the company’s stock price, but it might lead to a decrease in employment stateside.

4. American investors’ homeward bias has probably grown for the first time in years. As of 2010, more than 70 percent of the stocks and 80 percent of the bonds held by households and institutional investors in the United States originated on home soil. These were big numbers, given that American securities made up under half of each of those asset categories worldwide. But in fact, the bias in Americans’ investment had been dropping steadily for years — and it even fell during the aftermath of the global financial crisis, when American securities were seen as a safe haven.

Since 2010, however, securities in the United States have been among the world’s best performers. Without rebalancing their portfolios by diversifying some of those gains away from American assets, investors here would have ended up with a stronger homeward bias once again. The question is whether they’ve been active enough to do the rebalancing. If they haven’t, they’re probably leaving money on the table; with so many securities and markets to choose from around the world, an investor who diversifies should be able to maintain lower risk with the same return versus one who doesn’t. It may take a couple of years before more recent data on the home bias — to confirm or dispel this possibility — become available.

5. You can buy index funds or exchange-traded funds for almost anything. There’s no excuse for home bias these days, anyway, since most investors can purchase a chunk of exposure to dozens of economies, industries, and market sectors from the comfort of a laptop. Think Indonesia will take off after its recent election? There’s an exchange-traded fund for that. Convinced that wind energy is the wave of the future? Here’s an index fund just for you.

These vehicles could completely transform investing. It will no longer be about the fundamentals of individual companies but rather about broad ideas and trends. Stock-pickers and brokers will have to change their definition of a hot tip. And some of the traditional indices, like the Dow Jones industrial average, will be too narrow or idiosyncratic to use as barometers for markets.

Via FRED/research.stlouisfed.org

6. The average non-institutional investor is at a huge disadvantage. Back in 1980, institutions — from investment banks and pension funds to insurance companies and mutual funds — held only about a third of all stocks in the United States. By 2010, that share had doubled. These investors trade bigger blocks of shares than individuals and gather much more comprehensive information about the underlying assets (though they may not always use it).

Moreover, they can trade more frequently and, when new information becomes available, more quickly. When American household investors are sleeping, institutions are buying and selling from far-flung trading floors. Trading foreign securities using news you read in the morning paper will only leave you chasing trains that have already left the station. So investors who reduce their home bias face a trade-off: more diversification and potentially better returns for less day-to-day control of their holdings. This trade-off could actually supply some useful discipline; in the face of institutional investors’ advantages, a buy-and-hold strategy that minimizes trading makes the most sense. But that doesn’t help household investors when they make their initial purchase.

And you know what? That’s fine. Household investors don’t have a right to the same economies of scale and access to information as the heavy hitters, just because they feel like playing the market. They can still protect themselves, though, by paying a little attention to the big changes. And the biggest one of all is the continuing integration of global capital markets.