This Special Report will be the last in a 3 part series.
Wed May 04 2016
The first report I explained that one of the most importantvariables that makes stocks, markets go up: growth in the economy. I alsoexplained what markets stocks, markets go down: recessions and contractions inthe economy.
The second report I explained a very important variable thatmakes stocks, markets go up: growth in earnings is a reflection of growth in wealthcreation by a company for its shareholders. Contraction in earnings, or lossescause stocks and markets to go down. Investors are looking for growth andwealth creation, not losses or no growth.
Interest Rate Are Key to Stocks and Markets Going Up/Down
Interest rates are very important to the economy and assetvaluations.
Interest rates andthe Economy
Interest rates are essentially the price, cost of money. Thelower the rates, the more demand, the higher the potential for growth in theeconomy. The decision to buy or expand if you’re a business or consumer iseasier when rates are low.
High rates are detrimental to the economy: it raises thecost to expand, to grow, to buy big ticket items like housing or autos.
Interest Rates andInvestments
The main variable of many asset valuations models isinterest rates. These asset valuation models include: the discounted cash flowmodel, capital asset pricing model, dividend discount model, and the earningsyield.
In most of these models, when interest rates are low, assetswill be valued higher because assets have more value ( a dollar can go furtherwhen inflation is low versus when inflation is high) when interest rates andinflation are low, and because the economy can do better.
When interest rates and inflation are high, cash flows areworth less in the future when discounted to the present. Also when therisk-free rate (treasuries) is high, models tell investors to put money intreasuries because their safer, and riskier assets look less appealing.
Also when interest rates and inflation are moving higher,money leaves financial assets and moves into real assets (gold, real estate) toprotect an investor from inflation. The economy also tends to slow, or contractwhen inflation and interest rates are rising.
When interest rates are high enough, money will leave stocksand move into high interest rate investments, including tax-frees, corporateand government bonds, and short-term money markets. Stocks can’t compete wheninterest rates get high enough. As mentioned above, the economy tends to slowor contract when interest rates are high.
Interest Rates and the Markets in the 1970s
The 1970s had the oil embargo andan energy crisis causing cost push inflation and rising interest rates. We alsohad bad monetary policies.
Below is a chart of the Dow 30and the 10-year treasury:
Inflation and interest ratesessentially went up for most of the 1970s. This was a very difficult time forthe markets and stocks.
The market was essentially thesame value as it was in 1970 and 1978, 1979.
In the 1980s, we went from oil supply embargos,disruptions to oil gluts by the mid-1980s. Inflation and interest rates fell,the market took off.
You will notice in all the charts in this report, that wheninterest rates are rising (blue trendlines), the market (orange trendlines)normally falls. When interest rates are falling, the market normally rises.
Also helping the markets in the 1980s were better monetarypolicies, and baby boomers were starting families and buying homes.
Rates did start to rise in 1987 because of a strong economyand the 1980 to 1988 Iran/Iraq war caused concerns of oil supply disruptions.
The markets crashed in 1987 for some of the reasons above.The market crash was more of a market event than economic event as the economycontinued to grow.
Interest rates fell and the market recovered in the late1980s
Most of the 1990s benefitted from mostly low inflation andinterest rates, and the digital, technology revolution.
The fed did start raising rates in 1994 to slow theeconomy. The market stalled in 1994, butthe tech boom started in earnest by 1996.
Post Great Recession
The Fed has kept interest rates lower thannormal to stimulate the economy and reflate assets.
Interest rates went to historic lows in 2012 and testedthose lows in 2015.
When inflation and interest rates are low, the economy has abetter probability to grow, and this should lead to growing earnings. Lowinterest rates, a growing economy and earnings are ideal for stocks andmarkets.
When inflation and interest rates are high, the economy canslow or contract leading to lower earnings or losses and falling stock pricesand markets.