Among the most important forces affecting stock prices are inflation, interest rates, bonds, commodities, and currencies. Sometimes the stock market suddenly reverses, usually followed by published explanations worded to suggest that the writer’s keen observation enabled him to predict the turn of the market. Such circumstances leave investors somewhat awestruck and awed by the endless amount of ongoing factual input and foolproof interpretation required to avoid going against the market. While there are continuous sources of information one needs to successfully invest in the stock market, they are finite. If you contact me on my website, I’d be happy to share a few with you. However, what is more important is having a solid model to interpret any new information that is presented. The model must take into account human nature as well as the main market forces. The following is a cyclical model of personal work that is neither perfect nor complete. It is simply a lens through which you can view sector turnover, industry behavior, and changing market sentiment.
As always, any understanding of the markets begins with the familiar human traits of greed and fear, along with perceptions of supply, demand, risk, and value. The emphasis is on perceptions where group and individual perceptions generally differ. Investors can be trusted to seek the highest return with the least amount of risk. The markets, which represent group behavior, can be trusted to overreact to almost any new information. The subsequent bounce or easing in prices makes it seem like the initial responses have a lot to do with nothing. But no, group perceptions just swing between extremes and prices follow. It’s clear that the overall market, as reflected in leading averages, affects more than half of a stock’s price, while earnings account for most of the rest.
With this in mind, stock prices should rise with falling interest rates because it becomes cheaper for companies to finance projects and operations that are financed through loans. Lower borrowing costs allow for higher earnings that increase the perceived value of a stock. In a low interest rate environment, companies can borrow by issuing corporate bonds, offering rates slightly above the average Treasury rate without incurring excessive borrowing costs. Existing bondholders hold on to their bonds in a falling interest rate environment because the rate of return they are receiving exceeds anything offered on newly issued bonds. The prices of stocks, commodities, and existing bonds tend to rise in a declining interest rate environment. Loan rates, including mortgages, are closely tied to the 10-year Treasury interest rate. When rates are low, lending increases, effectively putting more money into circulation with more dollars chasing a relatively fixed number of stocks, bonds, and commodities.
Bond traders continually compare the interest rate yields of bonds with those of stocks. Stock returns are calculated from the reciprocal P/E ratio of a stock. Earnings divided by price gives the earnings yield. The assumption here is that a stock’s price will move to reflect its earnings. If stock returns for the S&P 500 as a whole are the same as bond returns, investors prefer the safety of bonds. Bond prices then go up and stock prices go down as a result of the movement of money. As bond prices rise due to their popularity, the effective yield on a given bond will decrease because its face value at maturity is fixed. As effective bond yields continue to fall, bond prices peak and stocks begin to look more attractive, albeit with increased risk. There is a natural oscillatory inverse relationship between stock prices and bond prices. In a rising stock market, equilibrium is reached when stock yields appear higher than corporate bond yields, which are higher than Treasury yields, which are higher than bond rates. savings accounts. Long-term interest rates are naturally higher than short-term rates.
That is, until the introduction of higher prices and inflation. Having a greater supply of money in circulation in the economy, due to increased borrowing under low interest rate incentives, causes commodity prices to rise. Changes in the prices of raw materials permeate the entire economy and affect all durable goods. The Federal Reserve, seeing higher inflation, raises interest rates to remove excess money from circulation and hopefully lower prices once again. Borrowing costs rise, making it harder for companies to raise capital. Stock investors, perceiving the effects of higher interest rates on corporate earnings, begin to lower their earnings expectations, and stock prices fall.
Long-term bondholders keep an eye on inflation because the real rate of return on a bond is equal to the yield on the bond minus the expected rate of inflation. Therefore, rising inflation makes previously issued bonds less attractive. Then the Treasury Department has to increase the coupon or interest rate on newly issued bonds to make them attractive to new bond investors. With higher rates on newly issued bonds, the price of existing fixed coupon bonds falls, causing their effective interest rates to rise as well. So both stock and bond prices fall in an inflationary environment, mainly due to the anticipated rise in interest rates. Domestic stock investors and existing bondholders view the interest rate hike as bearish. Fixed income investments are more attractive when interest rates are falling.
In addition to having too many dollars in circulation, inflation can also be increased by a drop in the value of the dollar in the currency markets. The cause of the dollar’s recent decline is the perception that its value has declined due to continued national deficits and trade imbalances. Foreign products, as a result, can become more expensive. This would make US products more attractive abroad and improve the US balance of trade. However, if before that happens, foreign investors are perceived to find US dollar investments less attractive and put less money into the US stock market, a liquidity problem may result in falling prices. stock prices. Political turmoil and uncertainty can also cause the value of currencies to decline and the value of commodities to rise. Commodity stocks perform quite well in this environment.
The Federal Reserve is seen as a gatekeeper that walks a fine line. You can raise interest rates, not only to prevent inflation, but also to keep US investments attractive to foreign investors. This particularly applies to foreign central banks that buy large amounts of Treasuries. Concern about rising rates worries both stock and bond holders for the reasons mentioned above and stock holders for yet another reason. If rising interest rates take too many dollars out of circulation, it can cause deflation. So companies can’t sell products at any price and prices drop dramatically. The resulting effect on stocks is negative in a deflationary environment due to a simple lack of liquidity.
In short, for stock prices to move smoothly, perceptions of inflation and deflation must be in balance. A disturbance in that equilibrium is often seen as a change in interest rates and the exchange rate. Stock and bond prices typically swing in opposite directions due to differences in risk and the changing balance between bond returns and apparent stock returns. When we find them moving in the same direction, it means that a major change is taking place in the economy. The fall in the US dollar raises fears of higher interest rates, negatively impacting stock and bond prices. The relative sizes of market capitalization and day trading help explain why bonds and currencies have such a large impact on stock prices. First, let’s consider total capitalization. Three years ago, the bond market was 1.5 to 2 times the size of the stock market. In terms of trading volume, the daily trading ratio for currencies, Treasuries, and stocks was then 30:7:1, respectively.