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Among the largest forces that strike stock prices are inflation, interest rates, bonds, commodities and currencies. At times the stock market on the spur of the moment reverses itself followed typically by published explanations phrased to suggest that the writer’s keen observation permitted him to predict the market turn. Such circumstances leave investors somewhat awed and astonished at the infinite amount of proceeding factual input and infallible interpretation needed to avoid going against the market. While there are continuing sources of input that one needs in order to invest successfully in the stock market, they are finite. If you contact me at my web site, I’ll be happy to share some with you. What is more important though is to have a robust model for interpreting any new information that comes along. The model should take into account human nature, as well as, major market forces. The following is a personal working cyclical model that is neither perfect nor comprehensive. It is simply a lens through which sector rotation, industry behavior and modifying market opinion can be viewed.

As always, any intellect of markets begins with the familiar human traits of greed and fear along with perceptions of supply, demand, risk and value. The stress is on perceptions where group and individual perceptions usually differ. Investors can be depended upon to seek the largest return for the least amount of risk. Markets, representing group behavior, can be depended upon to over react to almost any new information. The subsequent price rebound or relaxation makes it seem that initial responses are much to do about nothing. But no, group perceptions simply oscillate between extremes and prices follow. It is clear that the general market, as reflected in the major averages, impacts more than half of a stock’s price, while earnings account for most of the rest.

With this in mind, stock prices should rise with descending interest rates because it becomes cheaper for companies to finance projects and operations that are funded through borrowing. Lower borrowing costs allow higher earnings which increase the perceived value of a stock. In a low interest rate environment, companies can borrow by issuing corporate bonds, offering rates more or less above the average Treasury rate without incurring excessive borrowing costs. Existing bond holders hang on to their bonds in a falling interest rate environment because the rate of return they are receiving exceeds anything being offered in newly issued bonds. Stocks, commodities and existing 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 rates are low, borrowing steps up, effectively putting more money into circulation with more dollars chasing after a relatively fixed quantity of stocks, bonds and commodities.

Bond traders continually compare interest rate yields for bonds with those for stocks. Stock yield is computed from the mutual P E ratio of a stock. Earnings divided by price gives earning yield. The assumption here is that the price of a stock will go to reflect its earnings. If stock yields for the S&P 500 as a whole are the same as bond yields, investors prefer the safety of bonds. Bond prices then rise and stock prices wane as a result of money movement. As bond prices trade higher, due to their popularity, the effective yield for a given bond will decrease because its face value at maturity is fixated. As effective bond yields decline further, bond prices top out and stocks begin to look more attractive, although at a 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 stock yields appear higher than corporate bond yields which are higher than Treasury bond yields which are higher than savings account rates. Longer term interest rates are naturally higher than short term rates.

That is, until the introduction of higher prices and inflation. Having an increased supply of money in circulation in the economy, due to increased borrowing under low interest rate incentives, causes commodity prices to rise. Commodity price alterations permeate throughout the economy to affect all hard goods. The Federal Reserve, seeing higher inflation, raises interest rates to absent excess money from circulation to hopefully reduce prices once again. Borrowing costs rise, making it to a greater extent hard for companies to raise capital. Stock investors, perceiving the effects of higher interest rates on company profits, begin to lower their expectations of earnings and stock prices fall. Long term bond holders keep an eye on rising prices 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 then increase the coupon or interest rate on newly issued bonds in order 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 increase, as well. So both stock and bond prices fall in an inflationary environment, mostly because of the anticipated rise in interest rates. Domestic stock investors and existing bond holders find rising interest rates bearish. Fixated return investments are most attractive when interest rates are falling.

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