by Ruth
For 20+ years, putting money in the bank wasn’t a good investment strategy because the interest rate was so low. Where else to invest? Trying to strike a risk-return balance wasn’t easy. I developed my own method of selling puts to buy stocks and selling calls to sell stocks (discussed in my book, Are Your Health and Finances Linked? A Christian Entrepreneur’s Quest, https://www.amazon.com/dp/B0BQ5JXFYY). In doing so, I garnered a decent return on my investment.
In early 2022, the situation changed because the Federal Reserve Bank started to raise the interest rate. The discussion surrounding how central banks employ interest rates to control inflation is a topic worthy of its own exploration, but it is beyond the scope of this article.
As the interest rate rises, the stock market becomes more volatile and the stock prices tend to decrease. Several friends have requested an explanation from me. Here are a few notable reasons that I would like to outline:
1. Cost of borrowing: When interest rates are high, borrowing costs for companies increase. This results in decreased expansion, leading to decreased corporate profits and lower stock prices. Higher interest rates also lure investors to withdraw from the stock market and invest in fixed-income assets like bonds or CDs.
2. Discounted cash flows: Stock valuations rely on the concept of discounted cash flows. When interest rates rise, the discount rate used to calculate the present value of future cash flows also increases. This causes the value of future cash flows to decrease, leading to lower stock prices.
3. Alternative investment options: As mentioned above, when interest rates are high, fixed-income investments become more appealing, and investors may shift money out of stocks into bonds or other fixed-income assets, leading to a decrease in stock prices.
4. Consumer spending and borrowing: Higher interest rates also make it more expensive for people to borrow money, which can limit their ability to make big purchases, such as homes or cars. This can impact consumer spending and business revenues, leading to lower stock prices.
5. Currency exchange rates: Higher interest rates often attract foreign investors seeking higher returns, which will result in a stronger domestic currency. A stronger currency can make exports more expensive and less competitive, which negatively impact the earnings of companies with significant international exposure, leading to lower stock prices.
Can you think of other links between the interest rate and the stock market? Your input will be much appreciated.
Please note that the relationship between interest rates and the stock market is not straightforward. Other factors, such as market sentiment, international events (e.g., wars), and policy decisions, can also influence stock prices. Moreover, different sectors of the stock market may respond differently to changes in interest rates. Therefore, please conduct thorough research before making investment decisions. Personally, I tend to capitalize on market fluctuations. In the event that the stock market continues to decline, I may consider gradually expanding my equity portfolio by selling put options to acquire additional stocks.
