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How the Market Works

The Seven Year Itch

Posted by kdadmin on July 30th, 2014.

If you’ve been in a long term relationship, you’ve probably heard of The Seven Year Itch. Supposedly, around year seven, interest in monogamy often starts to wane. If you don’t know what I’m talking about, just google the phrase “Marilyn Monroe Seven Year Itch.”

Now consider the stock market. This month marks seven years since the height of the last bull market (July, 2007). Which was seven and half years after the peak of the previous bull market (January, 2000). Do you remember what happened after those peaks? It starts with a “P.”

Pain. And lots of it.

Do you like roller coasters? Take a gander at the S&P 500 since July, 1993.

7 Year Itch Edited Boo.jpg

(Source: Yahoo Finance)

While the current leading economic indicators point to continued economic growth, that doesn’t mean that the bond market isn’t all wonky because of the impact of QE123. Just look at your own portfolios, bonds have been selling above par, especially higher yielding bonds. But that recently changed. (See School Zones & The Bond Market).

So, if the bond market falters (bonds drop in value and start selling closer to par), bond owners who plan to sell before maturity will be unhappy. But, if you don’t own bonds, who cares, right? Wrong.

Let’s say you own a large manufacturing company. You need to borrow substantial capital to invest in parts, materials, and labor to make your products. Currently, because interest rates are so low, you’ve been able to borrow far more money than you could previously. As such, you’ve been more profitable than your historic averages and your stock price has gone up.

Now, let’s say that the bond values start to drop, which pushes yields higher. This means that you will have to pay higher rates to get access to the same capital. If you are currently paying 2%, imagine what paying 3% or 4% will do to your profitability. Your costs to carry capital could increase by 50% or 100%. Do you think this will be good or bad for your bottom line? Bad. If you raise your prices to cover this extra expense, do you think your customers will buy more or less of your products? Less.

If this is bad for your bottom line, what will likely happen to your stock price? Will investors want to pay more for your less profitable stock? Nope. They will want to pay less. And less. And less. Now, multiply this impact over tens of thousands of companies, and imagine what could happen to the stock market.

My point is not doom and gloom. My point is that sometimes it’s smart to sit out for a few periods. This is why we still have an abnormally large amount of money on the sidelines, in cash. In other words, I prefer to leave the potentially catastrophic consequences of The Seven Year Itch to Marilyn Monroe and the silver screen.

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