Why Are Stocks Rising Along With Interest Rates?

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Rising Rates and Higher Stock PricesAt the close of trading on April 5, two closely watched investing thresholds were approached, though not crossed. The Dow Jones Industrials flirted with 11,000, and 10-year Treasurys landed just shy of 4%. The former ended at 10,974, and the latter at 3.98% (the rate did touch 4% at one point). Generally, rising interest rates send stock prices in the opposite direction, but lately that correlation isn't holding. Why is that?

In truth, there's no way to know what moves stocks up or down. One popular theory is that stocks discount future corporate earnings. Based on that theory, higher interest rates would mean a higher discount rate, which would mean lower stock prices. But that theory works only if investors assume that the higher interest rates came with no change in future corporate earnings growth. And that may be an invalid assumption.

More specifically, investors may be assuming that higher interest rates are the strongest signal available indicating that the bond market now sees a stronger economic recovery than it did before, thanks to last Friday's jobs report. And stocks may be rising because investors have concluded that the boost in corporate earnings related to that economic recovery will dwarf the negative impact of a higher discount rate.

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Another theory for what moves stocks has to do with money flows. If more cash is flooding into a class of securities than is flowing out, then the securities receiving the net boost in cash will rise in price. This may also be behind the current rise in stocks.

How so? It's not hard to imagine that investors who are selling bonds and still sitting on $3.4 trillion in money market funds might be trying to decide what to do with all that "dry powder." Many of those investors may have remained on the sidelines as the S&P 500 rose about 40% since Barack Obama was sworn into office. And they may now decide that last Friday's jobs report signaled a real reason to believe the economic recovery is beginning in earnest.

In that case, as long as investors believe that the risk of missing out on faster growth in corporate earnings exceeds the risk of a stock price collapse, they'll keep buying stocks.

For now, higher interest rates are tilting the balance of risk in favor of missing out on growth. Higher interest rates probably will smash stocks. But not for a few more years.
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