Why didn't the stock market crash on 26Aug16 after stronger case for interest rate hike?

[Maverick74]

I still don't understand the economics behind higher rates and lower stock prices. For over 100 years, higher rates equate to higher stock prices in the first half of the rate cycle. Sure the market is desperately due for a pullback and a rate hike might be an excuse to sell off for 2 or 3 days but I think most of ET doesn't understand the economics of interest rates and the demand for money. We need to change the name of this website.

 

[piezoe]

No, he is not saying that.

But he's still a lunatic! (Schiff, I mean.)

 

[JackRab]

I still don't understand the economics behind higher rates and lower stock prices.

A few things...

- Stocks are mostly valued on future cashflows discounted at risk free rates.. so higher rates mean lower discounted cashflows.

- Kinda falls in the previous one... a higher interest rate means eventually bonds have higher yields and this creates a shift towards bonds compared to equity.

- Higher interest rates mean higher costs of capital (debt).

- You can also argue that rates rise because if inflation creeping up and this means higher incomes for companies based on higher sales values... until inflation hits crazy levels and rates rises a lot sharper to push inflation back down, which again makes cost of capital more expensive and hence lower stocks...

But, it's all about expectations...

 

[piezoe]

I still don't understand the economics behind higher rates and lower stock prices. For over 100 years, higher rates equate to higher stock prices in the first half of the rate cycle. Sure the market is desperately due for a pullback and a rate hike might be an excuse to sell off for 2 or 3 days but I think most of ET doesn't understand the economics of interest rates and the demand for money. We need to change the name of this website.

Maverick, the dynamic may be changing. We are in uncharted territory. universal low interest rates, "low inflation", and employment that by the old standards would be considered full, but we know that it's not full, because the ranks of the unemployed have been reduced by artifice.

 

[piezoe]

A few things...

- Stocks are mostly valued on future cashflows discounted at risk free rates.. so higher rates mean lower discounted cashflows.

- Kinda falls in the previous one... a higher interest rate means eventually bonds have higher yields and this creates a shift towards bonds compared to equity.

- Higher interest rates mean higher costs of capital (debt).

- You can also argue that rates rise because if inflation creeping up and this means higher incomes for companies based on higher sales values... until inflation hits crazy levels and rates rises a lot sharper to push inflation back down, which again makes cost of capital more expensive and hence lower stocks...

But, it's all about expectations...

That's the traditional viewpoint. Do we have to modify it?

 

[JackRab]

That's the traditional viewpoint. Do we have to modify it?

No why? I get your previous point... that we are in uncharted territory, but any investment decision should be based on and geared towards maximum return, taking into account a range of expectations.

Those expectations are arguably hard to gage at this point in time... But if you have the choice, you go for max return based on certain risk.

Now, will we stay in low interest rate... that depends on inflation...
Will we stay on low/zero inflation... I doubt that. But in the end that depends on demand for goods and services, and only if we enter into a decreasing (world-) population we will hit long term lower demand and deflation. Or if technology will continue to make productions/manufacturing more efficient and cheaper. End then also long term low/negative interest rates....

I don't see why that relationship will not hold.

That's in a nutshell what's been happening with Japan in the last few decades.. no population growth and therefore ageing and lower consumptions... That's a ball the Japanese will not be able to stop rolling unless they change immigration policies etc.
And hence they had the "lost decade" and have continuously low interest rates... and still have issues getting everything going, especially since world consumption has slowed in the last 10 years.

 

[Martinghoul]

A few things...

- Stocks are mostly valued on future cashflows discounted at risk free rates.. so higher rates mean lower discounted cashflows.

- Kinda falls in the previous one... a higher interest rate means eventually bonds have higher yields and this creates a shift towards bonds compared to equity.

- Higher interest rates mean higher costs of capital (debt).

- You can also argue that rates rise because if inflation creeping up and this means higher incomes for companies based on higher sales values... until inflation hits crazy levels and rates rises a lot sharper to push inflation back down, which again makes cost of capital more expensive and hence lower stocks...

But, it's all about expectations...

it's actually a difficult question... While the DD models suggest a mechanical connection, the correlation, in fact, is a lot more tenuous. There's quite a lot of discussion of this out there, but the upshot is that it's just not obvious.

 

[Maverick74]

it's actually a difficult question... While the DD models suggest a mechanical connection, the correlation, in fact, is a lot more tenuous. There's quite a lot of discussion of this out there, but the upshot is that it's just not obvious.

Only certainties in life are death and taxes. Everything else is a mixed bag.

 

[Martinghoul]

Only certainties in life are death and taxes. Everything else is a mixed bag.

Well, even taxes appear to be rather uncertain these days, especially if you're a certain large US corporate based in a certain European country...

 

[JackRab]

it's actually a difficult question... While the DD models suggest a mechanical connection, the correlation, in fact, is a lot more tenuous. There's quite a lot of discussion of this out there, but the upshot is that it's just not obvious.

True, but I like to simplify things to show the general idea. It never works exactly as theory says, that's why the markets are not totally efficient. Expectations change, technology changes... everyone has different views. But eventually the tendency is to go for the highest return compared to risk.