Why do Interest Rates and Inflation move the Stock Market?
In this month’s Newsletter, I’m going to tackle one main topic. Why does the stock market move with talks of Inflation and Interest rates? Personally, I don’t feel as there is enough education on the “why” two items move the market.
Index Update (As of 08/31/2022 from Yahoo Finance)
S&P 500 (Large Cap): -15.63% YTD | +12.79% 10 Year Return
Russell 2000 (Mid, Small Cap): -17.69% YTD | +9.53% 10 Year Return
Global Market – ex US: -20.92% YTD | +4.37% 10 Year Return
Why is the stock market moving so much because of Inflation and Interest rates? Since the beginning of the year, this has been a recurring question and conversation I’ve been having with clients. I feel as though I must apologize for not thinking to put this in a newsletter earlier than now.
I will warn any reader of this that this can get technical and tricky very quickly, so these short statements are not going to fully articulate and explain all the complexities, but this will certainly help move the needle of education and understanding in the right direction.
Inflation Example: When we buy equity in a company, stock, we are buying the future value of that company. Because when we buy a company, we’re wanting that stock price to increase in the future, right? Well, one of the main drivers of company share price value is future cash flow.
Let me develop this over simplified example, let’s say I buy the neighborhood lemonade stand for $100 in year 2020, and historically, this stand kicks off $50 of free cash-flow each year. So I ended up buying the business for 2x the free cash flow ($50 x 2 = $100), pretty good little business!
So now with owning this lemonade stand, I can do whatever I want with this $50. So, in years 2020 and 2021 I’m very happy because I’m getting $50 and I’m doing “stuff” with this $50.
But then 2022 happens and I’m still getting $50 but we all know that this $50 can’t buy as much “stuff” because of inflation, this $50, adjusted for inflation, might be worth $40-$45. And now, let’s say that I want to sell the business. Because inflation has eroded my purchasing power of $50/year, so when selling this business, I’ll likely need to sell it for $80-90 because that $50 of cash flow simply cannot buy as many goods or services.
When we think of equity stock value, this same idea applies in that the company’s cash-flow isn’t as valuable today as it was last year which in turn creates a lower company stock price. **Again, a very simplified and very imperfect example but hopefully good enough to get the point across**
Interest Rate Example: It’s no surprise that the Federal Reserve is increasing interest rates, personally my guess is we’ll see another 75 basis point move, but this doesn’t always directly correlate as to why the market is lower. **Again, a very simple example and very imperfect, but this should help**
There are multiple reasons as to why this drives the market lower but I’ll focus on two of them
1. Company Debt financing: the majority of company debt is based on a floating interest rate, as opposed to a fixed rate, like a fixed rate mortgage. When interest rates fall, the cost to pay the interest falls as well, conversely, when interest rates rise, the cost to pay the interest rises which has a dollar for dollar impact on company earnings. Of course with a reduction in earnings the company stock price will fall as well. To take this further, companies with higher levels of debt have seen their company stock fall further than companies with low levels of debt.
2. Personal Consumption: this second point is very similar to the first in that if I’m going to borrow money to buy a home or car or whatever, I won’t buy as much because the interest rate is higher so it’ll cost more each month. Let’s take this a few more steps further. Let’s say I don’t buy as much furniture because of the higher interest rates, which in turn creates lower company profit and a lower commission for the furniture sales person. So now the company has less earnings and profit to redistribute to their employees or business and the sales person has less income to maintain their standard of living. Which of course creates lower spending down the line and so on and so on. This ripple effect is being seen in some industries more than others, but is certainly having an impact on current company stock prices. Finally, the converse is once again true where should interest rates fall, that will create an accelerating ripple through the economy.
Tight Money versus Loose Money
When you study the markets, you’ll read about “tight” or “loose” money supply. One of the most common indicators of “tight” money supply is when the dollar is strong relative to other currencies and when commodity prices are weak. A “tight” money supply has historically been a way to lower inflation rates. Below are two recent charts that help make the point of a potentially “tight” money supply.
My favorite Inflation Chart
Today, we certainly have high prices, and when looking under the hood at the level of money supply (M2), it does appear this figure is starting to cool off. The below chart is tracking inflation (red) and M2 in (black). (source) Please note the red line starting to dip lower
Additional Data: Each month I get asked by clients what additional resources I’d encourage reading. This month I have three. Please hear me in stating I’m not trying to predict anything whatsoever, just some data I’m watching.
Inflation Reduction Act - AEI.org – Personally, I’m quite not sure how more spending will reduce inflation
Breakeven Inflation Rate - Federal Reserve – 5-Year Breakeven inflation rate of 2.51%, which is down from 2.72% last month
Forward P/E - JP Morgan – PE ratios continues to hovers near the 25 year average, which is starting to look like a base amount of support.
Market Truths
1. The Stock Market cannot be consistently known or timed
2. The Economy (as you define it) cannot be consistently known or timed
3. Over the past 100 years, the market has returned 10.45% (with dividends reinvested). It’d be difficult for someone to achieve this return if they did not simply stay invested. Data Source
4. The average intra-year market decline is about 14% and the market drops 15% or more every 3 years. J.P. Morgan | American Funds
5. Investing in equities has historically been volatile, my guess is it always will be, however when you consider equities (using the S&P 500 as a proxy), Real Estate, short-term bonds and corporate bonds, over the long-term, equities continue to be the historical winner. To crystallize this point, just look for yourself NYU.edu.
Market Beliefs
1. Because the future cannot be known, we must embrace the belief that the world isn’t going to end during our lifetimes, and if it does, our money doesn’t matter
2. The world has continued to advance, since well before Jesus walked the earth, so assuming the world doesn’t end, it’s rational to believe the world will continue to advance
In closing: We of course cannot control what the market does from here and we cannot predict when the next market downturn will occur. But we can control our behavior to these outside events and continue to stick with our long-term investment strategy.
As always, thank you for your trust, if you have any questions/concerns please contact me.
-Dave
David Hobbs, CFP®
Wealth Advisor | Owner
Hobbs Wealth Management
Standard & Poor’s 500 (S&P 500) - a market-cap weighted index composed of the common stocks of 500 leading companies in leading industries of the U.S. economy.
Russell 2000 – The index measures the performance of the small-cap segment of the US equity universe. It is a subset of the Russell 3000 and includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.
MSCI ACWI ex USA – The index measures the performance of the large and mid-cap segments of the particular regions, excluding USA equity securities, including developed and emerging market. It is free float-adjusted market-capitalization weighted.
Federal Funds Rate - refers to the target interest rate set by the Federal Open Market Committee (FOMC). This target is the rate at which commercial banks borrow and lend their excess reserves to each other overnight.
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