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If I've been looking at graphs correctly, there is a strong positive correlation between stock prices (or P/B values) and interest rates over time, i.e. P/B values tend to be high when interest rates are high.

Why is this? Does this not contradict the following two cornerstones:

1) Asset prices are formed by discounting future cash flows. When interest rates are high, the discount factor is high, and thus the price should be lower.

2) When interest rates are low, people tend to invest more in stocks, driving their price up.

I guess there's something wrong with my thinking here? If you can, please refer to relevant studies in this area.

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  • $\begingroup$ Take a look at quant.stackexchange.com/questions/12741/… $\endgroup$ – Helin Oct 8 '14 at 13:51
  • $\begingroup$ In fact this question is nearly a duplicate of the question that @haginile points to ... $\endgroup$ – Richard Oct 9 '14 at 6:37
  • $\begingroup$ What kind of interest rates specifically are you referring to? FED funding rate, government bonds, corporate bonds yield? $\endgroup$ – emcor Oct 9 '14 at 7:10
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This is a good question. There are various views to this. I will share some thoughts:

  • Higher interest rates mean lower bond prices for bonds already emmitted. Investors switchting between bonds and stocks could sell bonds and buy stocks in times of rising yields (fearing that his developement will last) which increases demand for stocks
  • Why do interest rates increase? If the increase is related to an increase in expected inflation then investors could seek inflation protection. It is arguable but stocks can be seen as real assets meaning that their prices tend to rise with inflation. Another reason why stocks could be attractive.

Some thoughts about your points:

Ad 1): the discounting model for stock prices is just a model. It certainly does not hold true at all times for all markets. I would not use it - however, some do.

Ad 2): When interest rates are low in order to provider liquity then this is true and this could be an explanation of the stock bull market that we have seen. Furthermore if yields on governent bonds are low: what is there to be gained? If interest rates can only have one direction to go (if this scenario is by far the most likely) then a bonds position is likely to lose. Stocks and credits are more attractive. We have seen this in the recent past.

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  • $\begingroup$ Not sure why you think dividend/earnings discount models do not hold true at all times. They are pretty widely used for obtaining "fair price" of equities. The key question is what discount rate is. Since dividends/earnings are not risk-free, you can't just plug in government bond yield – there's a risk premium. It may very well be the case the govt bond yields are increasing, and risk premium is declining, causing the overall discount rate to decline. $\endgroup$ – Helin Oct 8 '14 at 23:10
  • $\begingroup$ @haginile No, I don't believe that the discounted cashflow model reflects reality. Mabye it gives you some fair price but you never know when (!) the asset will trade at this fair price. It is not a binding law and as you say the parameters are uncertain. Your answer for the other question is good (+1), the correlation aspect is important. One could think that the correlation between stocks and bonds is fixed (negative) , which is not true as you point out. $\endgroup$ – Richard Oct 9 '14 at 6:36
  • $\begingroup$ "Why do interest rates increase?" Iirc, interest rates can be thought of like prices for loans? If that's so then isn't "Why do interest rates increase?" kind of like asking "Why do prices increase?"...But I'm guessing you're answering specifically for interest rates? $\endgroup$ – BCLC Nov 16 '14 at 14:12
  • $\begingroup$ No, if rates increase then prices for loans decrease (!). In the government bond market interest rates are vehicles that make traded prices match discounted cash flows. In the money-market world you can directly observe the artes. $\endgroup$ – Richard Nov 17 '14 at 12:45
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They are correlated because they share a common factor, namely expectations of future economic growth. Using the framework of a discounted cash flow valuation approach; the higher cash flows resulting from higher expected growth, more than compensates for the increase in the discount rate, hence a positive correlation. Periods of high inflation or deflation can break this however, as can QE.

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In the past, The Fed typically raised interest rates to help balance the money supply. When the economy is good and unemployment is low, the Fed raises rates to prevent an over-tightening of the money supply. This is traditionally how inflation works and when this happens it is actually a sign of health. Commodity prices tended to soar because there was increased demand of natural resources. When the Fed raises rates so high that is not in the best interest of investors to borrow money, that causes flight from equities into other instruments such as fixed income because bond prices are low and yields are high. This is where the Fed had to respond by lowering rates until borrowing money became attractive again and the cycle repeated.

What we have right now is a historic unprecedented downtrend in interest rates, which is partly due to the Fed's response to deflationary pressure, the credit crisis, and real unemployment. aka "quantitative easing." Money is cheaper than ever. But without real economic growth to drive rates higher, the only logical place to put excess liquid assets is the stock market. This has caused the market to continue ever higher, causing a rift in the correlation. Until the fed feels that it needs to tighten the money supply, this pattern will continue. When money starts to exit the equity market, the generals (investment banks) will re-evaluate. If projected earnings (real economic growth) are moving higher despite the tightening of credit, it doesn't matter. They will continue to invest their capital in companies causing the market to correlate with interest rates. This is the environment of a healthy market.

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