Hong Kong Meltdown Drove Many To U.S. Bond Market Stocks Should Benefit As Well From Reduced Pressure On Interest Rates

The bond market up and the stock market down has been a rare sight on Wall Street of late. But Thursday’s Hong Kong crash, and the subsequent global jitters, made bonds a popular alternative to heretofore bullish stock traders.

A lot of the money pouring into bonds is seeking a refuge from the Asian travails, making the proverbial “flight to quality.”

When the stocks get shaky, big money flows to the safest currency in the world: U.S. Treasury bills. Big money also flows into gold, other precious metals and oil stocks, all of which have gained in the last several days.

The stock market loves low interest rates. Why? Several reasons. With low interest rates, it’s easier for stocks to compete with low-yielding bonds for investor dollars. Also, companies can borrow money at low rates and have a better chance to expand their profits. Remember, corporate earnings drive markets higher.

Also, if you’re borrowing money to buy stocks, as many traders do, low interest rates make your borrowing costs lower.

So usually bonds and stocks go up in price together. Why do bonds go up in price when interest rates go down? Because bonds are fixed as far as coupon and principal. The only way a bond can adjust to interest rate changes is for the principal value to change. If interest rates go up, bond principal prices will go down, so that the cheaper price will make up for lower coupon rates.

As interest rates go down, the already-issued bonds containing the higher coupon rates will be more valuable and therefore go up in price. For example, suppose you have a 5 percent bond and interest rates go to 10 percent. The only way the 5 percent bond could sell during a 10 percent market environment is to be discounted. The 50 percent discount of principal matches the 50 percent discount in yield.

As usual, the time of most uncertainty is the time of greatest opportunity. And with investors fleeing the Hong Kong stocks, maybe now’s the time to consider them. You could buy Hong Kong stocks by buying ADRs (American Depository Receipts), which are traded here on the U.S. exchanges. Ask your broker or financial adviser for help in choosing specific issues.

Or you could buy a basket of high-yielding stocks on the Hang Seng through various unit trust offerings. There are many funds - both open and closed-end - that trade Hang Seng shares. Again, consult the financial magazines or check with your broker or financial planner.

Maybe the shake-up in the Asian markets will prove to be a long-term positive for U.S. markets. After all, the emerging markets have been among the fastest-growing markets for investors to employ funds - a risky proposition since most fund investors don’t realize how volatile emerging markets really are.

The markets “over there” are different: their financial reporting, their attitudes toward investors, but, most of all, the breadth of emerging markets are just not the same as the U.S. markets.

If you’ve invested in the Hong Kong markets, you’re hurting. Since the first week in August, that market has been down about 40 percent. Ouch.

The money that flies back here, vowing “never again” to invest in foreign markets, might be home for good. And, don’t forget, Hong Kong is one of the more liquid emerging markets. The smaller exchanges, such as Thailand and Singapore, are much less liquid.

This roiling over there may help our markets on a longer-term basis. With all the economic dislocations in Asia, there probably will be an economic slowdown. And because we’re now a global economy, this should slow economic pressures.

With a diminution in economic pressures, inflationary pressures should subside somewhat. Hopefully, enough to keep Alan Greenspan and the Federal Reserve Board from raising interest rates, something the market has feared for some time.

The lowest Hong Kong’s Hang Seng Index has sold on a price to earnings basis over the last 15 years or so is eight times earnings.

Recently that market was at 18 times earnings. Now, after the deluge, it is selling at 10 times earnings. By comparison, the Dow-Jones Industrial Average is selling at 20 times earnings.

John Brown, among others, thinks so. Brown, who manages money at Montgomery Asset Management, said it’s “not too early to start buying” Hong Kong shares.

So if you like contrarian investing and you have the stomach for it, this may be your chance to profit when others are running.