Among the most important forces affecting stock prices are inflation, interest rates, bonds, commodities, and currencies. Sometimes the stock market reverses suddenly, typically followed by posted explanations phrased to suggest that the writer’s keen observation enabled him to predict the market’s turn. Such circumstances leave investors somewhat in awe and awe at the infinite amount of continuous information and infallible interpretation necessary to avoid going against the market. While there are continuous sources of inputs that are needed to successfully invest in the stock market, they are finite. If you contact me on my website, I will be happy to share a few with you. However, what is more important is to have a solid model to interpret any new information that emerges. The model must take into account human nature, as well as the main forces of the market. 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 industry 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. Markets, which represent group behavior, can be trusted to overreact to almost any new information. The subsequent rally or relaxation of prices makes it appear that the initial responses have little to do with anything. But no, group perceptions simply oscillate between extremes and prices follow. It is clear that the general market, as reflected in the main averages, impacts more than half the price of a share, while earnings account for most of the rest.
With this in mind, stock prices should rise with falling interest rates because it is cheaper for companies to finance projects and operations that are financed through loans. Lower borrowing costs allow for higher returns 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 onto 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 an environment of declining interest rates. Rates on loans, including mortgages, are closely tied to the 10-year Treasury interest rate. When rates are low, loans increase, effectively putting more money into circulation with more dollars chasing a relatively fixed amount of stocks, bonds, and commodities.
Bond traders continually compare the interest rate returns of bonds with those of stocks. Stock performance is calculated from a stock’s reciprocal P / E ratio. Earnings divided by price gives an earnings yield. The assumption here is that the price of a stock will move to reflect its earnings. If the returns on S&P 500 stocks as a whole are the same as those on bonds, 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 move higher, due to their popularity, the effective yield of a given bond will decrease because its face value at maturity is fixed. As effective bond yields decline further, bond prices peak and stocks begin to look more attractive, albeit with higher risk. There is a natural oscillatory inverse relationship between stock prices and bond prices. In a rising stock market, equilibrium has been reached when equity yields appear higher than corporate bond yields, which are higher than Treasury yields, which are higher than rates. savings accounts. Longer-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 greater indebtedness under low interest rate incentives, causes the prices of raw materials to rise. Changes in commodity prices permeate the entire economy and affect all material 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 difficult for businesses to raise capital. Investors in stocks, sensing the effects of higher interest rates on company 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 equals the yield on the bond minus the expected rate of inflation. Thus, rising inflation makes previously issued bonds less attractive. The Treasury Department has to increase the coupon or interest rate of 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. Therefore, both stock and bond prices fall in an inflationary environment, primarily due to the anticipated rise in interest rates. Investors in domestic stocks and holders of existing bonds view rising interest rates as bearish. Fixed-yield investments are most attractive when interest rates are falling.
In addition to having too many dollars in circulation, inflation can also be increased by a fall in the value of the dollar in the currency markets. The cause of the recent decline in the dollar is perceptions of its diminished value due to continuing 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 trade balance. However, if before that happens, it is perceived that foreign investors find investments in US dollars less attractive and that they put less money in the US stock market, a liquidity problem can result in a fall in the prices of securities. Actions. Political turmoil and uncertainty can also cause the value of currencies to decline and the value of hard commodities to rise. Commodity stocks are doing quite well in this environment.
The Federal Reserve is seen as a watchdog who walks a fine line. You can increase interest rates, not only to prevent inflation, but also to keep American investments attractive to foreign investors. This is particularly true for foreign central banks that buy large amounts of Treasuries. Concern about rising rates makes both stock and bond holders uncomfortable for the reasons mentioned above and shareholders for another reason. If rising interest rates take too many dollars out of circulation, it can cause deflation. So companies cannot sell products at any price and prices drop drastically. The resulting effect on equities 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 balanced. An alteration in that equilibrium is usually 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 shifting balance between bond yields and apparent equity yields. When we find them moving in the same direction, it means that a major change is taking place in the economy. A fall in the US dollar increases fears of higher interest rates, negatively impacting the prices of stocks and bonds. The relative sizes of market capitalization and daily trade help explain why bonds and currencies have such a large impact on stock prices. First, let’s consider the total capitalization. Three years ago, the bond market was 1.5 to 2 times larger than the stock market. With respect to trading volume, the daily trading ratio of forex, Treasury bonds, and stocks was 30: 7: 1, respectively.