We put together the following “mental exercise” to shed light on why a bear market triggered by interest rates is different than a bear market caused by a collapse in business profitability, all else being equal.
“A dollar today is worth more than a dollar tomorrow, next month, next year, etc.”
Now, let’s do a quick mental exercise:
If we offered to give you a dollar next month, what would you pay us today for it?
You are smart, so maybe you would offer us 95 cents—because you need to be compensated for three things: 1) the risk that we won’t pay up (credit risk), 2) the gradual effect of inflation, and 3) the time that you went without access to your dollar.
The 5 cents profit is your investment return.
This is sort of how it works in the real world:
In the global market, this return is determined by supply and demand—the supply of dollars available looking for things to invest in, and the demand for dollars to borrow (to start businesses with, hire people, buy equipment, etc.).
But don’t forget the US Federal Reserve!
By holding the power to create or limit dollars, the Fed holds enormous power over both the supply and demand for dollars.
Going back to our previous example, let’s say the Fed raises interest rates. (The price of borrowing goes up.)
Now you’re only willing to pay 90 cents for that dollar next month. The required return is now higher as there are more competitive and rewarding options for investing/lending your precious dollar.
When you buy US stocks, you are buying the future income of US businesses.
For our purposes, this process is substantially identical to our example of you lending us 90 cents for a dollar next month. What happens when the price of borrowing goes up? Well, the price of buying future income goes down.
What if the price of borrowing money/buying future income is the only thing that changes?
Imagine a situation where interest rates go up, but businesses are still making just as much money as before. If you paid 95 cents for a dollar next month, sure, you are disappointed that you could have only paid 90 cents had you waited until interest rates increased, but you still end up with a dollar in the long run.
This mental exercise sheds light on why a bear market triggered by interest rates is different than a bear market caused by a collapse in business profitability, all else being equal.
Thus far, US corporate profits have remained remarkably resilient despite global economic headwinds. However, prolonged high interest rates could limit business investment and dent corporate profits in the long run.
This is the uncertainty that fuels investment risk and investment return.
Thanks for reading!
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