Why the Stock Market Going Up Means Nothing

(8 am – promoted by ek hornbeck)

So, after yet another rate cut by the Federal Reserve, along with better than expected earnings from Lehman Brothers today (who many feared would follow the path of Bear Stearns), the Dow rocketed up over 400 points.  Economy solved, right?

Nope.  Doesn’t mean anything.  Don’t let anyone fool you into thinking it does.

First of all, the market in equities is now a mere fraction of the size of the market in derivatives.  The assets which are toxic right now are derivatives; Collectivized Debt Obligations and Credit Default Swaps primarily.  The big problem is that everyone knows these derivatives are worth less than they thought, but no one is sure just how much less.  So, no one wants to buy them, out of the fear that the bottom is a long way off.  Compared to these assets, stocks are incredibly stable – the market should do alright, even as these assets get worse.

But second, stock prices increasing doesn’t by default mean what you might think.  For a neat example, Bear Stearns makes for a fascinating example.

The Fed-brokered JP Morgan bailout of Bear is at a share price of $2 a share, as most everyone aware of this story knows.  So why on earth did shares of Bear Stearns close at about seven dollars the day after the sale price was announced?

The big winners from the Bear Stearns acquisition are Bear’s bondholders. They came close to an event of default this weekend; if all goes according to plan, they’ll soon own nice safe debt from JP Morgan Chase. The only thing which can derail their glide path (if Krugman can mix his metaphors, so can I) would be if the deal doesn’t go through at $2 as planned.

The main thing that needs to happen for the deal to go through is that shareholders vote in favor. And the only way that bondholders can ensure yes votes for the deal is to own those shares and vote them themselves. Says Neubert: “They will eat the difference between where they buy the equity and $2.00 in order to protect much higher numbers in debt.”

There’s another reason for bondholders to buy stock above $2.

…if the deal falls apart, the value of the company might go down, all the way to zero eventually. But on the way there, volatility will be huge – and if volatility is high then the value of the equity will go up. In this sense, the equity is a hedge against the deal falling apart. If JP Morgan doesn’t buy Bear, bondholders’ bonds will fall in value – but their stock will rise, helping to offset the loss.

So, shares of Bear are going up because Bear’s bond holders are hoping those shares go down, and are planning to vote for the shares to be sold for less than they paid for them.  But the shares also make a nice hedge for them, since if the sale fails, their bonds will become worthless but their shares will go up.  But nothing about this at all speaks to any macro positive news about the state of the economy.