The Long-Term Implications of Today's Dow Drop


In the context of the 2,700-point advance we've seen in the Dow Jones Industrials since this time last year, this morning's 150-point drop is only a minor pullback. But substantial declines in bond markets around the world point to more than just a one-day event, instead reflecting the increasing concerns about the impact that the inevitable end of the Federal Reserve's quantitative-easing program will have on the financial markets. Given the extent to which the global economy has relied on low interest rates in the U.S. and elsewhere to drive its recovery attempts, the sharp upturn we've seen in bond rates has long-term implications for stocks both in the U.S. and around the world.

A look at the stocks that are leading the Dow lower today reveals the contribution higher interest rates have made to the overall market's declines. Despite strong consumer confidence, you'll find consumer giants McDonald's , Johnson & Johnson , and Coca-Cola all among the worst performers in the Dow today, with losses of more than 2%. Ordinarily, you'd expect these defensively oriented stocks to perform well in a downturn, as their businesses enjoy largely stable demand from loyal customers who rely on having those products regardless of economic conditions.

One way of explaining the disparity is to consider these stocks on a valuation basis. Lately, all three have seen their valuations vaulted higher, with Coke and J&J fetching more than 20 times trailing earnings and McDonald's weighing in with a multiple of almost 19. Those high valuations are reasonable in light of the rock-bottom interest rates that have prevailed for several years, pushing investors who would ordinarily prefer fixed-income investments into the stock market. But as interest rates rise, the bond-like flows of dividend payments that these secure stocks provide decline in value, therefore in many ways these stocks may well track the bond market in the absence of company-specific news to the contrary.

Interestingly, on the other side of the coin, Bank of America is one of the best performers today, gaining about 0.7%. Banks are sensitive to interest rates, but they can actually benefit from rising rates if the majority of the rate increases appear in long-term rates. A steepening yield curve can expand net interest margins and bolster overall earnings, and although higher rates also have a dampening effect on mortgage-refinancing activity and other important sources of revenue for banks, the overall impact isn't always so negative as you'd think.

Keep your eyes on rates
Stock investors aren't used to watching the bond market, but until the Fed's future course becomes clear, you'll want to pay attention to bonds. Otherwise, the moves you see in certain high-quality stocks won't always make sense.

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Fool contributor Dan Caplinger owns warrants on Bank of America. You can follow him on Twitter @DanCaplinger. The Motley Fool recommends Coca-Cola, Johnson & Johnson, and McDonald's. The Motley Fool owns shares of Bank of America, Johnson & Johnson, and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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