Stocks and bonds are the two major types of investment assets. Stocks are equity investments, representing ownership in a company. Bonds are debt investments, earning interest from a bond issuer. These two asset classes are driven by a range of economic factors. Some of these factors will push stock and bond values in different directions.
Bond prices are a function of current market interest rates. An individual bond pays a fixed amount of interest to an investor. Changing interest rates are accounted for in the bond market by changing bond values. Bond prices move in the opposite direction of rates. Rising interest rates result in falling bond prices and declining interest rates produce higher bond prices. Interest rates are a function of economic conditions and supply versus demand factors.
Stock Market Values
Individual stock values are determined by investor belief in the value of a company's business. Growing sales and profits usually result in higher share prices as investors buy shares to participate in the growth. The overall market is a reflection of economic expectations; A growing economy is good for profits and a slow economy leads to stagnant profit growth or losses. The overall stock market values are very emotion and crowd behavior driven, resulting in quick changes from a rising bull market to a declining bear market. The stock market is considered to be a leading economic indicator, with prices rising ahead of economic growth and bear markets staring before the economy slows.
Falling Stocks - Rising Bonds
Certain economic conditions will result in a falling stock market with a simultaneous rise in bond values. Stocks tend to fall in times of economic uncertainty or fear. These same factors push investors towards the safety of high quality bonds. As more money goes from stocks to bonds, stocks will continue to fall and bond prices will rise, resulting in falling interest rates. The move by investors to select the safety of bonds compared to the volatility of stocks will result in stocks and bonds moving in opposite directions.
Rising Stocks - Falling Bonds
A high level of economic activity and growth is usually a positive for stocks. Companies will be able to increase their prices, sell more products and grow their profits. A high level of economic activity may be viewed by government officials as inflationary and policies will be undertaken to slow economic growth. One tool to slow an economy is to raise interest rates. Higher rates mean lower bond prices, so as the stock market rises, bond prices fall.
Chickens and Eggs
Bond prices effects on the stock market and stock prices affecting bond values are like the chicken and egg question: Which came first? Bond and stock prices run on different cycles. The cause and effect factors for changing market prices take their time to start working, allowing the two markets to move in tandem before turning in opposite directions. Asset allocation into both stocks and bonds allow investors to be invested in both stocks and bonds, balancing the up and down cycles in an investment portfolio.