The Wall Street Waltz: 90 Visual Perspectives, Illustrated Lessons From Financial Cycles and Trends, Revised and Updated Edition

Chart 33

Remember What the Rich Man Forgot

This chart is similar to Chart 32 (the Panic of 1907) but includes three other important features: bond prices, the “Rich Man's Panic” of 1903, and an important lesson—that major stock market tops are usually preceded by at least a few months of falling bond prices. Bonds are represented in this chart by the single line. Look at 1905. Bonds had risen since mid-1903, but then they peaked and started falling in early 1905. Stocks kept rising until early 1906. Then they fell, which finally led into the Panic of 1907. Bond prices fell in line with stocks throughout 1907, and then they both rose together until year-end 1908. But again, falling bond prices in early 1909 foreshadowed the sharp decline to come in stocks.

Bonds fall before stock prices because of the relationship between bonds and interest rates. They move against each other. As interest rates fall, bond prices rise; as rates rise, bonds fall. Why? Bond prices adjust to interest rates, not the other way around. A bond's interest payment is a fixed yearly amount of dollars. As interest rates bounce around over time, an existing bond's price must bounce just the opposite way to keep the yield on that fixed yearly payment competitive with the newer interest rates from newer bonds.

But stocks also compete with interest rates. As seen in Chart 4, the earnings yield from stocks (earnings divided by stock prices) has to compete with interest rates. So, when bond prices fall, it means ...