If you’ve watched the stock market for the last year, you’ve likely noticed an odd phenomenon. When bad economic news is released, like the unemployment going up, the market actually goes up. When good news is released, like jobs numbers beating estimates, the market drops. Ever wonder why?
The answer is straight forward...but not intuitive. It all comes back to the way the market prices stocks and how interest rates affect stock prices.
Before I go too far, I want to note that this is the academic explanation. It’s a lot harder to separate cause and effect so directly in the real world. The effect isn't always 1 + 1 = 2 in real life.
How are stock prices determined?
Let’s start by looking at how stock prices are determined. The short answer is that stock prices are the present value of all future cash flows. The longer answer goes into the different methods of estimating and then discounting the future cash flows...but that's beyond our scope.
There are some incredibly complicated methods of estimating stock prices but I’m not going there. Instead, I’m going to show the simplest version, using ∑CF as the sum of all future cash flows and DR for the discount rate.
You’re probably wondering when I’ll mention the economy…I promise it’s coming.
Let’s rearrange the equation.
You’ve likely heard about the PE multiple…the discount rate is simply the inverse of that number, which is expressed as a percentage.
So let’s look at historical discount rates, as calculated by S&P 500 PE multiples, compared to the 10 Year US Treasury rate.
You’ll notice the correlation is high.
Historically the implied discount rate is highly linked to Treasury yields because of investor preference and utility. Fancy words, but they just mean that investors want investments with the best risk adjusted return. Stocks are riskier than Treasury bonds, so investors expect at least the same return as bonds, plus a bit extra to account for the extra risk. (That extra is called the equity risk premium).
This is where it gets a bit tricky.
The discount rate sometimes moves in anticipation of rate changes and sometimes in response, but in either case, rates set the tone for everything else.
When bond yields go down, so does the discount rate. When the discount rate goes down and earnings stay the same, stock prices rise. Going back to the equation we looked at earlier, a lower rate means a smaller divisor, which makes investors willing to pay more for a given stock.
So back to our original question, why does the market (often) go up when it hears bad economic news?
Bad news increases the probability that the Federal Reserve will cut interest rates. If interest rates are cut, then bond yields will correspondingly drop, as will the discount rate for equities.
For example, when the most recent jobs report was released, it wasn’t great. It wasn’t terrible but it showed the labor market is cooling off. A slowing job market is another data point the Federal Reserve will look at when they consider cutting rates.
This doesn’t apply when the economic data is inflation data. In the case of inflation, the market firmly wants positive inflation data that shows inflation trending towards the Federal Reserve goal of 2%. If Consumer Price Index or Producer Consumption Expenditures price index shows inflation growth, that is bad all around.
How this should affect your portfolio
The big takeaway from all this is that small changes aren’t important, and you can ignore most of the noise. The small changes that occur based on one data point or release are inconsequential in the long-term.
If you’re a long-term investor, and I expect anyone reading this is, the best thing you can do is ignore the noise.
You’re investing for ten, fifteen, or even thirty years in the future. Day to day changes are irrelevant. Your behavior will play the biggest role in your long-term success.
When I say your behavior, I mean a two things specifically. The first is that you need to keep investing on a regular basis. Time in the market is the key here. Compound growth doesn't happen if you don't give it the time. Second, you can't time the market, so you need to stay invested. If you sell and keep your money in cash, you're likely to miss out on the upswing. Missing out on the upswing tends to be more expensive than the amount you would have lost had you stayed invested through the downswing.
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