One of the largest forces that affect stock prices are inflation, interest rates, bonds, commodities and currencies. Sometimes the stock market suddenly reverses itself followed by printed explanations phrased to suggest that the author’s keen observation allowed him to predict the market turn. Such circumstances leave investors somewhat awed and amazed at the infinite amount of continuing factual input and infallible interpretation required to avoid going against the industry. While there are continuing sources of input that one needs to be able to invest successfully in the stock exchange, they are finite. If you contact me at my website, I’ll be happy to share some with you. What’s more important though is to have a strong model for distributing any new information that appears. The model should take into consideration human nature, in addition to, major market forces. The following is a private working cyclical model that’s neither perfect nor comprehensive. It’s only a lens through which industry rotation, business behavior and changing market sentiment can be looked at.
As always, any understanding of markets starts with the recognizable human traits of greed and fear together with perceptions of supply, demand, risk and value. The emphasis is on senses where individual and group perceptions usually differ. Investors can be depended on to seek out the biggest return for the least amount of risk. Markets, representing group behaviour, can be depended upon to over respond to almost any new info. The following price rebound or comfort makes it seem that initial responses are much to do about nothing. But no, group perceptions simply oscillate between extremes and costs follow. It’s apparent that the overall market, as reflected in the significant averages, affects over half of a stock’s price, while earnings account for most of the rest.
With this in mind, stock prices should rise with decreasing interest rates as it becomes cheaper for businesses to finance operations and projects that are financed through borrowing. Lower borrowing costs allow higher earnings that raise the perceived value of a stock. In a low interest rate environment, businesses can borrow by issuing corporate bonds, offering prices slightly above the normal Treasury speed without incurring excessive borrowing costs. Present bond holders hang on for their bonds in a falling interest rate environment since the rate of return they are getting surpasses anything being offered in newly issued bonds. Stocks, commodities and present bond prices tend to rise in a falling interest rate environment. Borrowing rates, including mortgages, are closely tied to the 10 year Treasury interest rate. When prices are low, borrowing increases, effectively putting more money into circulation with more dollars following a relatively fixed amount of stocks, bonds and commodities.
Bond traders always compare interest rates for bonds with those for stocks. Stock yield is calculated in the reciprocal P/E ratio of a stock. Earnings divided by cost gives earning yield. The premise here is that the purchase price of a stock will move to reflect its own earnings. If inventory yields for the S&P 500 as a whole will be the same as bond yields, investors prefer the security of bonds. Bond prices then rise and stock prices fall because of money movement. As bond prices trade higher, because of their popularity, the effective yield for a given bond will decrease because its face value at maturity is fixed. As successful bond yields decline further, bond prices top out and stocks start to look more appealing, although at a greater risk. There’s a natural oscillatory inverse relationship between stock prices and bond rates. In a rising stock market, equilibrium was reached when inventory yields seem higher than corporate bond yields that are greater than Treasury bond yields that are greater than savings account rates. Longer term interest rates are naturally higher than short term prices.
That is, until the introduction of high prices and inflation. With an increased supply of cash in circulation in the market, because of increased borrowing under low rate of interest incentives, causes commodity prices to rise. Commodity price changes permeate throughout the economy to affect all hard goods. The Federal Reserve, seeing greater inflation, increases interest rates to eliminate extra money from flow to hopefully reduce costs once more. Borrowing costs rise, which makes it more challenging for companies to raise capital. Stock investors, perceiving the effects of higher rates of interest on business profits, begin to reduce their expectations of earnings and stock prices drop.
Long term bond holders keep your eye on inflation since the actual rate of return on a bond is equal to the bond yield minus the expected rate of inflation. Therefore, rising inflation makes previously issued bonds less attractive. The Treasury Department must then increase the interest or coupon rate on newly issued bonds to be able to make them appealing to new bond investors. With higher rates on newly issued bonds, the purchase price of existing fixed coupon bonds drops, causing their interest rates to increase, also. So both bond and stock prices fall in an inflationary environment, mostly due to the anticipated increase in interest rates. Domestic stock investors and existing bond holders find increasing interest rates bearish. Fixed return investments are attractive when interest rates are decreasing.
Along with having too many dollars in circulation, inflation is also raised by a fall in the value of the dollar in foreign exchange markets. The reason for the dollar’s recent fall is perceptions of its diminished value because of continuing national deficits and trade imbalances. Foreign goods, because of this, can be expensive. This would make US products more attractive overseas and improve the US trade balance. But if before that happens, foreign investors are perceived as locating US dollar investments less attractive, putting less money into the US stock market, a liquidity problem may lead to falling stock prices. Political turmoil and uncertainty may also result in the value of monies to reduce and the value of hard commodities to grow. Commodity stocks do very well in this environment.
The Federal Reserve is viewed as a gate keeper that walks a fine line. It can increase interest rates, not just to avoid inflation, but also to create US investments remain attractive to foreign investors. This especially applies to overseas central banks who buy tremendous quantities of Treasuries. Concern about increasing rates makes both bond and stock holders uncomfortable for the aforementioned reasons and stock holders for still another reason. If rising interest rates require a lot of dollars from circulation, it can result in deflation. Companies are then not able to sell products at any cost and costs fall dramatically. The consequent impact on stocks is negative in a deflationary environment because of simple lack of liquidity.
In short, in order for stock prices to proceed easily, perceptions of inflation and deflation has to be in balance. A disturbance in that equilibrium is usually viewed as a change in interest rates and the currency rate. Stock and bond costs normally oscillate in opposite directions because of differences in risk and the shifting balance between bond yields and apparent stock yields. As soon as we find them moving in precisely the exact same way, it means a significant change is happening in the economy. A falling US dollar increases fears of higher interest rates that affects bond and stock prices negatively. The relative sizes of market capitalization and daily trading help clarify why currencies and bonds have such a massive effect on stock prices. First, let us consider total capitalization. Three years ago the bond market was from 1.5 to 2 times bigger than the stock exchange. Regarding trading volume, the daily trading ratio of monies, Treasuries and stocks was subsequently 30:7:1, respectively.