The Wall Street Waltz: 90 Visual Perspectives, Illustrated Lessons From Financial Cycles and Trends, Revised and Updated Edition

Chart 10

Never a Timer Be: 56 Years of Stocks and Interest Rates

Trying to outguess the stock market is futile, but folks keep at it. Ironically, most people think that if they could forecast interest rates they would be able to forecast stock prices. But it works just enough to get you into trouble.

It's natural to assume interest rates drive stock prices, and sometimes they seem to. Lower interest rates are thought to stimulate economic activity. Increased economic activity leads to higher sales, lower borrowing costs, and therefore stronger corporate earnings. Falling rates make the returns from alternative investments seem more attractive than they had been before the rates fell. When rates rise, the process should, by all logic, work in reverse. Higher rates should simultaneously cripple corporate earnings and make the returns on earnings seem less appealing comparatively.

But somehow it doesn't always work out. This chart shows 56 years of the Dow Jones Industrial Average (DJIA) and two key interest rates. The discount rate is the interest rate charged by the Federal Reserve System to troubled member banks for borrowed funds. This rate and the rate for prime commercial paper (see Chart 45) provide good proxies for short-term interest rates over this period. If you study the other interest-rate examples in this book, it won't surprise you the two rates move in tandem. (On this chart, the lines representing the interest rates are split. to keep the DJIA index intact and fit ...