Q: What do interest rates have to do with the stock market?
A: That’s a great question, and the answer is: more than you think. There are two main relationships — first the competition for your investment choices, and second the effect that interest rates have on the companies that issue stocks.
Regarding the competition issue, imagine that interest on intermediate length bonds pay 8% a year (and assuming inflation is low). Long-term stock returns are around the same return, but the returns are much more volatile.
So, why buy stocks when you can get a similar return with stable fixed income investments? A second competition for your investing dollar is the effect that higher interest rates would have on what you spend your money on besides investments. As interest rates rise individual investors might have less money to spend on stock investments-their mortgage and car loans cost more and disposable income drops. The reverse is also true — dropping and lower interest rates means that stocks are more attractive than bonds, and result in many families having more disposable income with which to invest.
As interest rates rise, companies might make less money. Most companies consistently borrow money for expansion and operations. As they pay more to borrow the money they may need to operate, they may see profits drop proportionally. Since stocks are often valued by how much in earnings and profit their underlying companies make, higher interest rates would be expected to hurt stock earnings and prices. The long-term profit potential and growth of the company might also be negatively affected for the same reasons. By the way, one industry that might do well with higher interest rates is banking, as the banks can increase their lending rates even more than their cost of borrowing.
Much of the movement in stock market prices with changes in interest rates is based on expectations. You might notice a drop in stock market prices suddenly if the Federal Reserve hikes rates “more than expected,” and vice versa.
There are also some confounding variables that might affect how stocks respond to interest rate changes. If the economy is strong, the Federal Reserve might be worried about inflation and would then raise the short-term interest rate (the Federal Funds Rate). But remember that the reason they did this is a strong economy-which might allow companies to make more money than usual (especially if the individual company does not borrow much). So rising rates in a strong economy might not have the effect expected. Conversely, the Fed lowering rates due to a sluggish economy might not induce companies to borrow and expand (often referred to the Fed as “pushing on a string).”
Even though it seems that we should be able to define future stock market prices based on interest rates changes, these variables can be significant factors. Like almost everything else we think that will help us discern short-term moves, this information may not help either.
Steven Podnos is a fee-only financial planner in Central Florida. He can be reached at [email protected] and at www.WealthCareLLC.com.