Why Are High Interest Rates Bad for Stock Prices?

by Karen Farnen

Political unrest, weather disasters and many other unpredictable factors influence the gyrations of the stock market. However, investors study various economic indicators when trying to understand the market over the short term. When interest rates rise, for example, money generally flows out of the stock market, and stock prices decrease. Over the long term, however, other factors outweigh interest rates in moving stock prices.

Real Interest Rates

One commonly reported interest rate is the market or nominal interest rate, which is the rate charged for loans. The real interest rate has more influence on stocks, however. To calculate the real interest rate, subtract the rate of inflation from the market rate. High real interest rates mean a high return on fixed-income investments, such as bonds and bank certificates of deposit. The guarantee of a high return elsewhere makes stocks less attractive. Investors move money to these alternative investments, so stock prices fall. On the other hand, stock prices rise when low real interest rates diminish returns from bonds.

Price to Earnings

One indication of the willingness of investors to pay for stocks is the price to earnings ratio, or P/E ratio. Find this ratio by dividing the price of one share of stock by the earnings per share, as reported on the company website. According to the Financial Industry Regulatory Authority, historically the P/E ratio for stocks has averaged approximately 15. When interest rates rise, the P/E ratio falls. This shows that investors are not willing to pay as much for stocks.

Influence of Inflation

Higher inflation generally causes an increase in interest rates and a drop in stock prices, especially over the short term. Inflation also reduces your true return on stocks. However, stocks normally provide a good real return when inflation stays at 5 percent or below, according to "Kiplinger" contributing editor Jeremy L. Siegel. This is because stocks represent ownership of actual factories and businesses. Over the long term, the return from stocks doesn't change much in periods with or without inflation, Siegel states.

Earnings and Growth

Higher interest rates drive down stock prices by their effect on earnings and growth. Individuals must pay more to buy goods on credit, pricing some buyers out of the market. High rates also increase a company's borrowing costs for raw materials, equipment or new factories. As business receipts fall and costs rise, profits decrease and expansion slows down. This brings down stock prices. A decrease in interest rates, on the other hand, helps the stock market by making it easier for businesses to grow and for consumers to purchase goods and services.

Short and Long Term

Interest rates have greater influence on stock prices over the short term. Over a period of five years or greater, growth in corporate profits is more important. Since the second World War, profit growth has accounted for approximately 90 percent of stock market increases, according to CNN money."The Wall Street Journal" agrees that growth is the most important factor in stock prices over many years.

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