Well, there’s the simple equation you used to describe the effect of interest rates on asset prices, but it doesn’t really tell us much about how swings can affect stock and bond prices. It can’t tell us about whether stocks and bonds will go up or down, for that matter, because swings in the stock market are affected by the stock market itself. It can, however, show when an individual stock or bond is becoming less valued by all of the other stocks and bonds out there—a stock becoming cheaper, for example, or a bond less valuable as its price rises.
So how can the swings in our stock market be explained? And that’s what Ben Graham and other early traders were looking at back in the 1800s: how stock prices move on their own, as well as the relationship between stocks and bonds to some degree. The relationship, as we’ve discussed before, is what makes investors decide to buy or sell stocks; and it has a lot to do with who and what a stock market is trading against—and, more importantly, what its competitors are doing against it.
And so to look at how swings in the stock market affect the market price of stocks, and what happens when two stock indexes move in different directions, we are going to look in detail at what is essentially a two-way mirror. What we’re going to do—and to see how it works—is follow the movement of two stock indexes that differ in relation to each other, as well as the direction and timing of the moves:
Figure 1: The two indexes that differ in relation to each other.
In the following figure, we present the average monthly price movements of the Standard & Poor’s 500 Index (in blue) and the Dow Jones Industrial Average (in green). We’ll go into more detail about the relationship between these two indexes and our current analysis at the bottom of the article, but in short, they represent two of the six main indices that constitute the U.S. stock market, and the differences in price movements are based on what the market is doing against the broader market.
To do this analysis, we look at an underlying indicator that tells us when the market is pricing in any kind of change between stocks and bonds. And that’s the price-to-earnings ratio.
Price-to-earnings ratio
There are three main kinds of price-to-earnings ratios used by the market—the forward earnings yield, the volatility spread, and the
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