Forces that move share prices

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 market’s turn. Such circumstances leave investors somewhat amazed and amazed at the endless amount of ongoing factual input and foolproof interpretation required to avoid going against the market. While there are continual 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 some with you. However, what is more important is to have a solid model to interpret any new information that comes along. The model must take into account human nature as well as major market forces. The following is a cyclical pattern of personal work that is neither perfect nor complete. It is simply a lens through which to 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 individual and group 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 relied upon to overreact to almost any new information. The subsequent bounce or relaxation in prices makes it seem as if the initial responses had a lot to do with nothing. But no, the group’s perceptions simply swing between extremes and prices follow. It’s clear that the overall market, as reflected in the major averages, affects more than half of a stock’s price, while earnings account for most of the rest.

With this in mind, share 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 are holding 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 existing stocks, commodities and bonds tend to rise in an environment of falling interest rates. Loan rates, including mortgages, are closely tied to the 10-year Treasury rate. When rates are low, lending increases, 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 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 decline 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 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 higher than corporate bond yields, which are higher than Treasury bond yields, which are higher than interest 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 greater borrowing under low interest rate incentives, causes commodity prices to rise. Changes in commodity prices permeate the entire economy and affect all tangible 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, sensing the effects of higher interest rates on company profits, begin to lower their earnings expectations and share 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. The Treasury Department then 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. National stock investors and existing bondholders view the rise in interest rates 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 foreign exchange markets. The cause of the dollar’s recent decline is the perception that its value has decreased 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 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 a downturn. of share prices. Political turmoil and uncertainty can also cause the value of currencies to decline and the value of commodities to rise. Commodity stocks do quite well in this environment.

The Federal Reserve is seen as a watchdog that walks a fine line. It can raise interest rates, not only to stave off inflation, but also to keep US investments attractive to foreign investors. This applies particularly to foreign central banks that buy large amounts of Treasury bonds. Concerns about rising rates worry 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 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 in balance. A disturbance 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 stock returns. When we find them moving in the same direction, it means that a major change is taking place in the economy. The decline 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 larger than the stock market. With respect to trading volume, the daily trading ratio for currencies, treasuries and stocks was then 30:7:1, respectively.