Monthly Discussion

Have Bonds said their Last Word?

In An S-Shaped Trail to Wall Street I discuss the competition between various investment instruments for investors' dollars. In particular there is a section describing a simplified ecology for the placement of assets, consisting of four basic "species": stocks, bonds, cash, and real estate. While buy-and-hold investors choose among them, the four species compete and interact with each other. For example, stocks behave like a predator to cash that behaves like prey, that is, the more money in the bank the more stock sales will grow. At the same time stocks and bonds elbow each other like rabbits struggling to secure grass in a crowded range. Such relationships—derived in the book from historical data— make much sense and seem rather obvious. But there are also some non-obvious findings.

We have two more years' worth of data since the publication of An S-Shaped Trail to Wall Street. The above picture changes little when we add the new historical data, in other words, it makes no difference for the buy-and-hold investor. But there is news for the trader, the active speculator, and certainly the broker.

In addition to the buy-and-hold investor—placement of assets—we have the question of how often investments get repositioned. By and large, investments change hands more frequently on the stock market than in banks or real estate. Trends on the traded value are not necessarily similar to trends on placed value. There is competition in both, but assets cumulating and volumes exchanging hands are different phenomena. The total assets in stocks may remain unchanged and yet the rate at which the dollar volume changes hands daily can fluctuate tremendously. However there is competition just the same. An investor that continuously buys and sells, chooses before acting, and at that moment the different alternatives compete for his or her favor.

Concentrating at the NYSE let us consider another simplified ecological system consisting of only two species, stocks and bonds. There exist many other instruments at the stock market but these two constitute a subset of the four considered earlier. One can also argue that they occupy a niche of their own. Under this assumption we may want to know how they interact in this niche and what kind of future they have.

For the 12 years preceding 1987 the two-species ecological model reveals a symbiotic relationship between stocks and bonds at NYSE. It means that each one influences positively the growth rate of the other. The more investors fuss over bonds the more they would fuss over stocks and vice versa. In particular, I find that every new dollar introduced in the bonds exchange triggers an increase in the growth potential of the stocks exchange volume by $337, whereas every new dollar introduced in the stocks exchange would trigger an increase in the growth potential of the bonds exchange volume by $29.

This win-win situation before 1987, however, is not exactly carefree. The benefit to stocks from bonds is so large that it masks a parasitic aspect in the evolution of the stocks exchange volume: stocks do not have the ability to multiply on their own! If the bond exchange volume were suddenly to become zero, the stock exchange volume would also decline and wither away within a few years. On the contrary, if the stocks volume were to become zero, the bonds volume would continue to grow, if at a slower rate. It may not be obvious to everyone but the bonds exchange played an indispensable role at the NYSE before 1987.

The crash of 1987 constitutes a perturbation large enough to cause mutations in the competitive roles of our two species so as to define a new type of relationship between them. Exhibit 3 shows the two-species ecological system since 1987. They now enjoy an amensal relationship. Amensal is a relationship in which one member is suffering from the existence of the other but the other is impervious to it. Now for every $450 increase in the stocks exchange volume there is a decrease of $1 in the growth potential of the bonds exchange volume, but new dollars going into bonds make no difference to stocks.

Exhibit 3. This figure from An S-Shaped Trail to Wall Street is updated here with three more data points. The data point for year 2000 has been scaled up from data only on the month of January, and therefore carries some uncertainty. The smooth lines are global fits to all data points according to the ecological model. The vertical scales are quite different for stock and bonds.

Under the new conditions the bonds exchange volume is declining and will continue to do so barring "mutations" like the ones triggered by the 1987 crash. According to the graph, the bonds exchange volume roughly halves every year. In the absence of disasters or other "abnormal" events, bonds would have less and less to say for the years ahead.