The Market Price Of A Bond Increases When The Forces that Move Stock Prices

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Forces that Move Stock Prices

The biggest forces that affect stock prices include inflation, interest rates, bonds, commodities and currencies. Sometimes the stock market reverses suddenly and an explanation is published suggesting that the author’s keen observation enabled him to predict the market turn. Such situations leave investors somewhat bewildered by the infinite factual input and incomparable interpretation required to avoid going against the market. Although the sources of inputs needed to invest successfully in the stock market are constantly available, they are limited. If you contact me on my website, I’d be happy to share some with you. It is even more important to have a robust model to interpret any new information. The model should consider human nature as well as major market forces. The following is a personal working cycle model that is neither perfect nor comprehensive. It is simply a lens through which to view sector movements, industry behavior and changing market sentiment.

As always, any understanding of markets begins with the familiar human traits of greed and fear, along with a sense of supply, demand, risk and value. Emphasis is placed on perceptions that group and individual perceptions are often different. Investors can rely on getting the biggest return for the least risk. Markets, representing group behavior, can be relied upon to overreact to almost any new information. Subsequent price increases or relaxations indicate that initial responses are nothing to do. But no, group perceptions only move between extremes and prices. It is clear that the general market, as reflected in the major averages, affects more than half of the stock price, while earnings account for most of the rest.

With this in mind, share prices should rise with falling interest rates as it becomes cheaper for companies to finance projects and operations funded by borrowing. Lower borrowing costs lead to higher earnings which increases the perceived value of the stock. In a low interest rate environment, companies can borrow by issuing corporate bonds, paying rates slightly above the average Treasury rate without incurring high borrowing costs. Existing bondholders hold on to their bonds in a falling interest rate environment because the rate of return they receive is higher than anything offered in newly issued bonds. Prices of stocks, commodities and existing bonds rise in a falling interest rate environment. Lending rates, including mortgages, are closely tied to the 10-year Treasury interest rate. When rates are low, borrowing increases, effectively putting more money into circulation with more dollars chasing a relatively fixed amount of stocks, bonds and commodities.

Bond traders compare the interest rate yield of bonds to the interest rate of stocks. Stock yield is calculated from the relative P/E ratio of the stock. Earnings divided by cost gives the earnings yield. The assumption here is that the stock price will move to reflect its earnings. If the overall S&P 500 stock yield is the same as the bond yield, investors prefer the safety of bonds. Bond prices then rise and stock prices fall due to money movements. As bond prices are higher, due to their popularity, the effective yield of a given bond will decrease because its face value is fixed at maturity. As effective bond yields fall further, bond prices move higher and stocks look more attractive despite higher 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 to be greater than corporate bond yields which are greater than Treasury bond yields which are greater than savings account rates. Long term interest rates are naturally higher than short term rates.

That is, until the introduction of high prices and inflation. As the money supply increases in the economy, the prices of goods rise due to increased borrowing under the stimulus of low interest rates. Changes in commodity prices affect all hard goods throughout the economy. The Federal Reserve, seeing high inflation, raises interest rates to drive down prices once again to remove excess money from circulation. Borrowing costs rise, making it more difficult for companies to raise capital. Stock investors, realizing the impact of higher interest rates on company profits, begin to lower their earnings expectations and share prices fall.

Long-term bondholders track inflation because the real 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 has to raise coupons or interest rates 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, which also increases their effective interest rates. So both stock and bond prices tend to fall in inflationary environments, mainly due to expected increases in interest rates. Domestic stock investors and existing bondholders see rising interest rates as bearish. Fixed return investments are most attractive when interest rates are falling.

In addition to having too many dollars in circulation, a fall in the value of the dollar in the foreign exchange market can also increase inflation. The dollar’s recent decline has been attributed to persistent national deficits and trade imbalances that have devalued the dollar. Foreign goods may, as a result, become more expensive. This would make US products more attractive abroad and improve the US trade balance. However, before that happens, foreign investors find US dollar investments less attractive, putting less money into the US stock market, a liquidity problem that could cause share prices to fall. Political turmoil and uncertainty can cause currencies to depreciate and hard commodities to appreciate. Commodity stocks do quite well in this environment.

The Federal Reserve is seen as a gatekeeper that walks a fine line. It could raise interest rates not only to curb inflation, but to keep American investments attractive to foreign investors. This is especially true of foreign central banks that purchase large amounts of Treasuries. Concerns about rising rates upset stock and bond holders for the above reasons, and stock holders for another reason. If too many dollars leave the currency due to rising interest rates, it can lead to inflation. Then firms cannot sell products at any price and prices fall sharply. A simple lack of liquidity has a negative impact on stocks in an inflationary environment.

In summary, for stock prices to move smoothly, the perception of inflation and deflation must be in balance. Changes in interest rates and foreign exchange rates disturb that balance. Stock and bond prices generally move in opposite directions because of the shifting balance between risk and bond yields and apparent stock yields. When we see them moving in the same direction, it means that there is a big change in the economy. A falling US dollar creates fears of higher interest rates which negatively affects stock and bond prices. The relative sizes of market capitalization and daily 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 one and a half to two times larger than the stock market. In terms of trading volume, the daily trading ratio of currencies, treasuries and stocks was 30:7:1 respectively.

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