Among the biggest forces affecting stock prices are inflation, interest rates, bonds, commodities, and currencies. Sometimes the stock market suddenly reverses itself and this is usually followed by published explanations that have been worded to indicate that the writer’s keen observation allowed him to predict the market’s turn. Circumstances like these leave investors somewhat horrified and amazed at the endless amount of constant factual input and fallible interpretation needed to avoid going against the market. While there are continuous sources of inputs that one needs in order to invest successfully in the stock market, they are limited. If you contact me on my website I will be happy to share some with you. Most importantly, however, is to have a strong model for interpreting any new information that comes along. The model must take into account human nature, as well as key market forces. What follows is a sample personal work cycle that is neither perfect nor exhaustive. It is simply a lens through which to look at 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 focus is on perceptions in which individual and group perceptions usually differ. Investors can count on getting the greatest return with the least amount of risk. Markets, which represent group behavior, can be relied upon to react overly to almost any new information. The subsequent bounce or relaxation in price makes it clear that the initial responses can’t be done with much about nothing. But no, collective perceptions simply oscillate between extremes and tracking prices. Obviously, the general market, as reflected in the major averages, influences more than half of the share price, while earnings account for most of the rest.
With this in mind, stock prices should rise as interest rates fall because it becomes cheaper for companies to finance projects and operations that are financed through borrowing. Lower borrowing costs allow for higher profits that increase the perceived value of the stock. In a low interest rate environment, companies can borrow by issuing corporate bonds, offering rates just above the average Treasury rate without incurring excessive borrowing costs. Existing bondholders are hanging on to their bonds in a low interest rate environment because the rate of return they receive exceeds anything being offered in newly issued bonds. Stocks, commodities and current bond prices tend to rise in a low interest rate environment. Borrowing rates, including mortgages, are closely related to the 10-year Treasury interest rate. When rates are low, borrowing increases, effectively putting more money in circulation with more dollars chasing after a relatively constant amount of stocks, bonds, and commodities.
Bond traders constantly compare the interest rate returns on bonds with the returns on stocks. A stock’s yield is calculated from the exchange’s price-to-earnings ratio. Profits divided by price gives the profit yield. The assumption here is that the share price will move to reflect its earnings. If stock returns for the S&P 500 as a whole are comparable to bond returns, investors would prefer the safety of bonds. Then bond prices rise and stock prices fall as a result of the movement of money. As the price of bonds increases, due to their popularity, the effective yield of a particular bond will decrease because the face value at maturity is fixed. As effective bond yields continue to fall, bond prices rise and stocks start to look more attractive, although with higher risks. There is a natural fluctuating inverse relationship between stock and bond prices. In a bullish stock market, equilibrium has been reached when stock returns appear to be higher than corporate bond yields which are higher than treasury bond yields which are higher than savings account rates. Long-term interest rates are naturally higher than short-term interest rates.
That is, until the introduction of price hikes and inflation. An increase in the money supply circulating in the economy, due to increased borrowing under the incentives of low interest rates, leads to a rise in commodity prices. Changes in commodity prices permeate throughout the economy to affect all hard commodities. The Fed sees inflation rising, and raises interest rates to remove excess money from circulation in hopes of lowering rates again. Borrowing costs are rising, making it more difficult for companies to raise capital. Stock investors, realizing the effects of higher interest rates on a company’s earnings, begin to lower their earnings expectations and lower stock prices.
Long-term bond holders watch inflation because the real rate of return on a bond is equal to the bond yield minus the expected rate of inflation. Therefore, higher inflation makes previously issued bonds less attractive. The Treasury Department then has to increase the coupon, or interest rate, on the newly issued bond in order to make it attractive to new bond investors. As the price of newly issued bonds rises, the price of existing fixed coupon bonds falls, causing effective interest rates to increase as well. So stock and bond prices fall in an inflationary environment, mostly due to an expected rise in interest rates. Domestic equity investors and existing bond holders find interest rates rising bearish. Fixed-return investments are more attractive when interest rates are low.
In addition to circulating too many dollars, inflation can also be fueled by the depreciation of the dollar in the foreign exchange markets. The recent decline in the value of the dollar is due to perceptions of a depreciation due to persistent national deficits and trade imbalances. As a result, foreign goods can become more expensive. This would make American products more attractive abroad and improve the US trade balance. However, if before this happens, foreign investors are perceived to find US dollar investments less attractive, and put less money into the US stock market, then the liquidity problem can drive down stock prices. Political turmoil and uncertainty can also lead to a depreciation of currencies and an increase in the value of hard commodities. Commodity stocks do well in this environment.
The Federal Reserve is seen as the gatekeeper who walks the thin line. It may raise interest rates, not only to prevent inflation, but also to make American investments remain attractive to foreign investors. This is especially true of foreign central banks that buy huge amounts of Treasuries. Concern about rising interest rates makes both stock and bond holders uncomfortable for the above reasons and equity holders for some other reason. If rising interest rates put a lot of dollars out of circulation, it could cause deflation. Then the companies are unable to sell the products at any price and the prices drop dramatically. The resulting impact on stocks is negative in a deflationary environment due to a slight lack of liquidity.
In short, for stock prices to move smoothly, perceptions of inflation and deflation must be balanced. A disturbance in this balance is usually seen as a change in interest rates and the foreign 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 there has been a major change in the economy. The decline in the US dollar raises concerns about rising interest rates, which will negatively affect stock and bond prices. The relative volumes of market capitalization and intraday trading help explain why bonds and currencies have a significant impact on stock prices. First, let’s consider the total capitalization. Three years ago the bond market was 1.5 to 2 times bigger than the stock market. In terms of trading volume, the daily turnover ratio of currencies, treasury bonds, and stocks at that time was 30:7:1, respectively.