Determinant 4 : The level of market interest rates

Determinant 4 : The level of market interest rates

The stock market, no matter how much it may think so,does not exist as a world unto itself. Investors should consider how much profit they can obtain elsewhere. Interest rates, if they are high enough, can offer a stable profitable alternative to the stock market. Consider periods such as the early 1980s when yields on prime quality corporate bonds soared to over 15 percent. Long-term bonds of somewhat lower quality were being offered at even higher interest rates.

The expected returns form stock prices had trouble matching these bond rates; money flowed into bonds while stock prices fell sharply. Finally, stock prices reached such a low level that a sufficient number of investors were attracted to stem the decline. Again in 1987, interest rates rose substantially, preceding the great stock market crash of October 19. To put it another way, in order to attract investors from high-yielding bonds, stock must offer bargain-basement prices. The point can be made another way by noting that since higher interest rates enable us to earn more now, any deferred income should be “discounted” more heavily. 

Thus the present value of any flow of future dividend returns will be lower when current interest rates are relatively high. The relationship between interest rates and stock prices is somewhat more complicated, however, than this discussion may suggest. Suppose investors expect that the rate of inflation will increase from 5 to 10 percent. Such an expectation is likely to drive interest rates up by about 5 percentage points to compensate investors for holding fixed-dollar-obligation bonds whose purchasing power will be adversely affected by greater inflation. Other things being the same, this should make stock prices fall. But with higher expected inflation, investors may reasonably project that corporate earnings and dividends will also increase at a faster rate, causing stock prices to rise. Usually, corporate earnings and dividends do tend to grow with inflation.

Thus, the last rule for the firm-foundation theory is:

Rule 4: A rational investor should be willing to pay a higher price for a share, other things being equal, the lower are interest rates.

The Level of Market Interest Rates. Photo by ElenaB.