Treasury Bond Rates vs. Stock Market

[Anonymous]

I think I understand that when bond rates go up stock prices drop. This is because a bond is a safer investment for the money so when you're earning 0% in bonds stocks are the only option for growth. What I don't understand is why relatively small increases in bond rates of return (like today, bond rate is around 1.53%) lead to relatively big drop in stock market (1.7% to 2.8% depending on which index you look at). 1.53% isn't that much compared to what the stock market returns historically, so why the big drop in the stock market? Or maybe these percentage changes are more significant than they appear to me?

Link to article showing the %s I cite. https://www.cnbc.com/2021/09/27/-stock-market-futures-open-to-close-news.html

[Anonymous]

I agree. I don't understand why a higher bond yield would eat away at tech firms' future profit value.

[Anonymous]

Correlation is not causation. The increase in interest rates doesn’t cause the market to crash. Maybe the market judges that equities are too risky, bonds become more attractive and demand drives up interest rates. Or maybe some event occurs that makes stocks less attractive and bonds more attractive.

Mr Market is irrational over the short term and you just have to hope you last long enough to get the theoretical benefits of an efficient market.

[Anonymous]

Anonymous wrote:Correlation is not causation. The increase in interest rates doesn’t cause the market to crash. Maybe the market judges that equities are too risky, bonds become more attractive and demand drives up interest rates. Or maybe some event occurs that makes stocks less attractive and bonds more attractive.

Mr Market is irrational over the short term and you just have to hope you last long enough to get the theoretical benefits of an efficient market.

Interest rates, bonds prices and stock prices are all reacting to the same economic news. If people are selling stocks and buying bonds the demand for bonds is increasing pushing up their price. As the price of bonds increases the interest rate on them actually decreases. If economic conditions are worse it is riskier for banks to make loans so they will need to charge higher interest rates.

[Anonymous]

It’s because of the leverage that is use in the stocks market

[Anonymous]

The relationship between stock prices and interest rates is the present value of future earnings. Look it up, but I’ll try a brief explanation. A dollar today is worth more than a dollar 5 years from now because in the second case 1) you have to wait 5 years to receive it (opportunity cost), 2) inflation, and 3) risk/uncertainty of capital return. The market’s way of expressing these factors is interest rates. For stocks, the dollar flow is earnings. Theoretically, the price of a stock is the sum of its future stream of earnings discounted by the relevant interest rate (one year, two years, etc. and for the appropriate riskiness of capital at risk) In other words, the longer you have to wait for and the more uncertain the earnings, the higher the return, or interest rate, required. Now, apply this to stalwart vs. speculative stocks. In the case of the stalwart, you get dependable earnings today and over the foreseeable future. However, with the speculative stock, it may lose money in the next few years before producing earnings in future years. That’s the future stream of earnings. Now, you need to bring those earnings dollars, which occur in different years, back to today’s value (present value). You do that by applying the appropriate interest rate to each cash flow. So, a dollar of earnings today is worth $1, but $1 of earnings in 5 years at 5% interest is worth only 78 cents [$1(1.05)^5]. And at 10% interest, it’s worth 62 cents. So, when market interest rates change, the discount factor for present valuing future earnings changes. And, as calculated above, higher rates make future cash flows worth less in today-dollar terms. Since stalwart stocks have lots of current and near-term earnings, their discounted future earnings stream is impacted less by a change in interest rates than a speculative stock’s earnings that may be small or negative until years to come.

That’s the numbers and theory. In reality, I think the market somewhat trades this way, but it also provides a great excuse to sell high-fliers that are overvalued during uncertain times.