It's generally believed changes in interest rates affect the stock market primarily because of the impact they have on companies' costs of borrowing. That's only partially true and probably not the primary driver.
Interest-bearing investments compete with stocks for investors' capital. When interest rates are high, investors prefer the safety of fixed income securities to the uncertainty of stocks. When interest rates are low by historic standards, stocks become more attractive than interest-bearing investments.
It's highly likely the current stock market is being heavily supported by historically low-interest rates. With interest rates on shorter-term investments currently paying well below 1% per year, investors will take a guaranteed loss when inflation is factored into the equation. The prospect of double-digit returns on stocks is much more attractive in this interest rate environment.
Conversely, a rising interest rate trend will usually be negative for stocks. Interest-bearing investments are simply too stable and offer guaranteed return stocks can’t promise.
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Ultimately, investing in the stock market is all about cashing in on the profits of the companies issuing the stocks. If corporate profits are generally on the rise, this supports higher stock prices. If profits are in a general decline, the market is more likely to retreat.
The state of the economy
This factor may not be worth mentioning as a specific market driver because it is mostly a big-picture summary of all the other factors that drive the market. But more generally, when the state of the economy is good — as indicated by a healthy growth rate in the gross domestic product (GDP) — businesses feel more confident in expanding, and investors are more likely to invest.
As well, if a growing economy translates into higher wages, workers will have more money to invest. They will also spend more money, which will flow into publicly traded companies and improve their earnings.
A declining economy, and especially a recession, results in a reversal of all of those positive dynamics. The net effect on the market is typically negative.
This goes beyond economic conditions in foreign countries. It's more about severe events such as a radical change in government in a friendly or formally stable country. It can also be the result of a contrived event such as the oil embargo or the recent coronavirus pandemic.
Perhaps the most serious impact happens in the case of war. This will be especially true early in the conflict when the outcome is most in doubt. Since the stock market hates uncertainty, war can have a very negative impact on the market.
At the opposite end of the spectrum, if any of these events are resolved in a positive way, the stock market typically resumes an uptrend.
International capital flows
This is a case where bad news can become good news. Economic or geopolitical troubles in major foreign economies can be a positive driver in the US stock market. This is because as conditions in foreign countries deteriorate, capital leaves those countries. Since the US is generally considered to be a safe haven for capital, much of the international flow comes into this country. And much of that flow ends up in the stock market.
In this way, economic troubles in, say, Europe, China, Japan or even a large number of emerging markets, could be a positive for US markets.
Should the economy in the US begin underperforming most other world economies, capital could begin flowing out of the US and out of the US stock market.
This is often tracked by surveys and opinion polls, which makes it an inexact science at best. But when people feel good about the state of the nation, its finances, the economy and the international balance, it usually has a positive impact on the stock market.
If, however, there is a high level of anxiety about the future, people will be more likely to hoard cash than to invest in stocks. That will have an obvious depressing effect on the market.
Supply and demand
This refers to supply and demand as it relates to the amount of stock that is available for public trading. Like every other commodity, stocks will generally rise when fewer are available. That plays out in different ways, and is likely having an effect on the current market.
This starts with stock buybacks. That's when companies buy back their own stock, which reduces the amount of stock for sale and usually increases the share price. That's been a significant trend in recent years.
But another factor may have to do with the reduction in the number of publicly traded companies. For example, the Wilshire 5000 Total Market Index started in 1974 and was so named because it represented the approximately 5,000 publicly traded companies on US stock markets. But the number has changed dramatically over the years.
The number of publicly traded companies covered by the index peaked at 7,562 companies in 1998, which was near the height of the dot-com bubble economy. However, the number of publicly traded companies has fallen to 3,473 as of Dec. 31, 2019.
Fewer publicly traded companies means more competition for available stocks. That raises the price of the surviving stocks, causing the market to rise.
Growth/decline in major industry sectors
Back in 2007, it became obvious two major economic sectors, banks and mortgage lenders, were in serious financial trouble. Stocks of companies engaged in those sectors plummeted. As they did, they pulled down the entire market, causing a decline of more than 50% in the major market indices.
By contrast, rapid growth in the technology sector resulted in the dot-com boom that propelled the stock market higher for most of the 1990s.
Major industry sectors can impact the stock market not only because they can improve the economy of the nation, but also because they create new investment opportunities. By contrast, when major industries are in trouble, the economy can weaken, and enthusiasm for stocks in general can dry up, causing stock prices to fall.
Given the number of factors that can cause the stock market to rise and fall, it can be very difficult to project where the market is headed. It's not just the occurrence of any of these factors, but the degree to which they happen. But in general, a severe change — whether good or bad — will likely affect the stock market at least in the short run.
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