Tuesday, June 25, 2013

Interest Rates Up Implies Stocks Down

The earnings and dividend yields on stocks sort of compete with the interest yield on bonds for investors.   The inverse of the P/E ratio, or E/P ratio, can be compared to the interest rate on bonds.  The idea is often called the Fed Model and makes sense as a starting point for stock valuations.  This is really why when the Fed forces interest rates down they can expect the stock market to go up.   But this implies that if interest rates double you should expect the stock market to go to half what it was.  I expect that algorithmic trading must take this into account.    At the moment the interest rates are up far more than stocks have gone down so far.  I think there is a good chance that interest rates keep going up.  The more bond values drop the less people want to hold them.  The more sellers there are, the more the value drops.   I think there is a high risk that the stock market goes down much more.

Here is E/P compared to interest rate on 10 year government bonds:

Here is E/P compared to interest rate on corporate bonds:

The graph below gives some idea of what is going on in corporate interest rates currently.  Just eyeballing, it looks like about 5% to about 7%, or about a 40% increase.  It could easily go up much much more.

 As corporate bond yields go up it really makes sense for stocks to go down.  Another way to think about this is that when companies can borrow money really cheaply an easy way to boost earning per share, and possible get executive bonuses, is to just borrow money and buy back some shares.  But when interest rates go up they won't do this so much.  So a major thing propping up the stock market will go away.

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