The stock market can be confusing, but one piece of advice has rarely steered CNBC's Jim Cramer astray: always keep an eye on bonds.
"Look, I know the bond market is boring, ... but it's much larger than the stock market, and more importantly, it's very important to the overall direction of stocks," the "Mad Money" host said.
When Cramer was running his hedge fund, he'd always call into the office with the same question when he was away from his desk: "Where are the bonds?"
"That's how much it mattered to me on a day-to-day basis," he said. "Yet stock market investors seemingly forget the bond market all the time."
Investors seemed to forget bonds in 2000, when the bond market signaled that the economy was softening right before the dotcom bubble burst, Cramer said. They seemed to forget again in the lead-up to the 2008 financial crisis, when the Federal Reserve raised interest rates 17 times, "precipitating the worst downturn since the Great Depression," he argued.
More recently, investors panicked when the yield on the 10-year U.S. Treasury broke above 3 percent, but when it pulled back, most of them went back to ignoring bonds, Cramer continued.
"Look, it should never come as a surprise that long-term interest rates are rising or falling. Bonds can punch your portfolio in the face if you aren't paying attention and a lot of people don't pay attention because, as I said, bonds are boring," the "Mad Money" host said.
"That's why I say: Don't forget bonds. Always keep those bond prices and interest rates right in front of you."
Here's how Cramer was taught to think about bonds when he was coming up at Goldman Sachs:
- Bonds are the true competition to stocks.
- When short-term interest rates — the ones set by the Fed — rise, expect high-yielding dividend stocks like American Electric Power to sell off.
- When long-term interest rates — the ones best represented by the 10-year Treasury yield — rise, be prepared for stocks to lose some value.
- When rising long-term interest rates are caused by an uptick in inflation, "that's a toxic brew."
- Higher interest rates don't just make bonds more attractive, but they make it more expensive for banks to give out loans, putting "a damper on the economy."
"It's simple: if the bond market competition gets more attractive, the stock market gets less attractive; this is indeed a zero-sum game," Cramer said. "For a long time, we had an ideal environment for stocks: low inflation and low interest rates. That's an incredibly benign backdrop and I don't want it to lull you into a false sense of security about the dangers of a big spike in rates. That's why you have to watch the bond market."