Money Goes Where it’s Treated Best

I recently received the following email from a subscriber in Georgia.

“I appreciate your musings several times each week.  Yesterday’s, with its reference to your parents’ anniversary, reminded me of a Cabot Market Letter many years ago in which your father wrote about the relative size of the bond market and stock market and, if I recall correctly, said that the bond market was quite a bit larger than the stock market.  In those days he used interest rates to predict whether money would have a tendency to flow from bonds towards equities or from equities towards bonds.  There was a chart each issue showing this tendency.  There was a maxim: “Money goes where it’s treated best” which summarized this tendency.  Anyhow, my question today is: Where is all the money?  I understand that there are trillions “on the sidelines.”  Is it in bonds, in money market accounts, in Swiss banks, in China?  Has it “disappeared?”  A bull market won’t get started until this money begins flowing towards equities and I, and probably others, would appreciate your take on where it has to come from. Again, I really appreciate you and all of the other Cabot editors who correspond with us.”

Regards,

G.B.

—

I answered his questions promptly but today I want to elaborate.

First, back in 1970s and 1980s, we had a market timing tool called the Power Index, which tracked the trends of interest rates.  Back then, when interest rates were high, they were an important lever of the Federal Reserve’s fiscal policy.  To slow the economy, the Fed would raise rates.  To accelerate it, they’d reduce rates.  And the Power Index, which was found on page 4 of every issue of Cabot Market Letter back then (along with our other market timing indicators), was a great indicator that helped us determine when rates had moved enough to force a change in the market’s trend.

Occasionally, when the Power Index told us we’d reached a major market bottom, and the Fed was busily lowering interest rates, we’d also print a graphic on page 1 illustrating the relative size of the stock and bond markets, in effect showing subscribers that the bond market was so much larger than the stock market that even pulling perhaps 5% of the money out of the bond market would cause a huge jump in stocks.

Back then, the phrase we used was “Money goes where it’s treated best.” I don’t claim that my father coined it, but I do know that he adopted it and he fed it well over more than two decades.

Then came the runaway bull market of the 1990s, fueled–as we know now–by loose credit and growing perceptions that the Internet would change everything.

In this new environment, rising interest rates lost their power to slow the economy, and in the bear market after the 2000 top, falling rates failed to stop the plunge; the Power Index stopped working, and we eventually dropped it.  For market timing Cabot Market Letter now uses two trend-following indicators and one that looks at the internal health of the market.

But the principle behind the aphorism remains.  Money goes where it’s treated best, or at least where investors perceive it will be treated best.

Today, as G. B. has noted, a lot of money is on the sidelines somewhere, because fear is high.  It’s in money market accounts paying 0.5%.  It’s in three-month T-bills yielding 0.3%.  And it’s in 30-year government bonds paying 3.5%, which is better than losing money, but will look pretty meager after the next bull market begins.

Finally, a lot of the money has “disappeared,” as prices of both stocks and (mainly corporate) bonds fell in the past year.  As prices recover, that money will “reappear,” but in different places, where investors perceive it will be treated best.

Bank of America and Citigroup, for example, will not see much recovery.  But young companies that have not yet been fully loved by investors will soar.  You can read about them here regularly.

But it won’t be falling interest rates that will kick off the buying.  It will be a fading sense of fear, and a growing sense of optimism that the profit opportunities in specific areas are too big to pass up. That’s why we rely on our trend-following indicators today; they’ll alert us to when that fear has indeed faded, whereas interest rates will not.