While there are continuing sources of input that one requires in order to invest successfully in the stock market, they are finite. What is more crucial though is to have a robust model for interpreting any new information that comes along. The model should take into perspective human nature, as well as, major market forces. The below mentioned is a personal working cyclical model that is neither perfect nor comprehensive. It is just a lens through which sector rotation, industry behavior and changing market sentiment can be viewed.

As pretty much always, any understanding of markets begins with the familiar human traits of greed and fear along with perceptions of supply, demand, risk and value. The main focus is on perceptions where group and individual perceptions usually differ. Investors can be depended upon to seek the biggest return for the least amount of risk. Markets, representing group behavior, can be depended upon to over react to almost any new facts and figures. The subsequent price rebound or relaxation makes it appear that initial feedbacks are much to do about nothing. But no, group perceptions just oscillate between extremes and prices follow. It is pretty much clear that the general market, as reflected in the major averages, impacts more than half of a stocks price, while earnings account for most of the rest.

With this in account, stock prices should rise with falling interest rates because it becomes cheaper for companies to finance projects and operations that are funded through borrowing. Lower borrowing costs give higher earnings which increase the perceived value of a stock. On the other hand in a low interest rate environment, companies can borrow by issuing corporate bonds, offering rates slightly above the average Treasury rate without incurring excessive borrowing costs. And that is where existing bond holders hang on to their bonds in a falling interest rate environment because the rate of return they are receiving exceeds anything being offered in newly issued bonds. Stocks, commodities as well as existing bond prices tend to rise in a falling interest rate environment. Borrowing rates, including mortgages, are more or less tied to the 10 year Treasury interest rate. When rates are low, borrowing enhances, effectively putting more money into circulation with more dollars chasing after a relatively fixed quantity of stocks, bonds and commodities.

Bond traders more often compare interest rate yields for bonds with those for stocks. In general Stock yield is computed from the reciprocal P/E ratio of a stock. Earnings divided by price offers earning yield. The main point of assumption here is that the price of a stock will move to reflect its earnings. In case if stock yields for the S&P 500 as a whole are the same as bond yields, investors prefer the safety of bonds. Bond prices then increase and stock prices decline as a result of money movement. As bond prices trade higher, because of their popularity, the effective yield for a given bond will decrease because its face value at maturity is fixed. As effective bond yields decline further, bond prices increase and stocks begin to look more attractive, although at a higher risk. Generally speaking there is a natural oscillatory inverse relationship between stock prices and bond prices. In a increasing stock market, equilibrium has been reached when stock yields appear higher than corporate bond yields which are higher than Treasury bond yields which are higher than savings account rates. Longer term interest rates are normally higher than short term rates.

That is, until the inception of higher prices and inflation. Having an increased supply of money in circulation in the economy, because of increased borrowing under low interest rate incentives, causes commodity prices to rise. Furthermore Commodity price changes permeate throughout the economy to affect all hard goods. The Federal Reserve, seeing higher inflation, increases interest rates to remove excess money from circulation to hopefully reduce prices once again. Borrowing costs increase, making it more difficult for companies to raise capital. Stock investors, perceiving the aftermath of higher interest rates on company profits, begin to lower their expectations of earnings and stock prices fall.

Long term bond holders keep a vigil eye on inflation because the real rate of return on a bond is equal to the bond yield minus the expected rate of inflation. Thats why, rising inflation makes previously issued bonds less attractive. The Treasury Department has to then enhance the coupon or interest rate on newly issued bonds in order to make them attractive to new bond investors. According to experts with higher rates on newly issued bonds, the price of existing fixed coupon bonds falls, causing their effective interest rates to increase, as well. Therefore both stock and bond prices fall in an inflationary environment, mostly because of the anticipated rise in interest rates. Domestic stock investors and existing bond holders find increasing interest rates bearish. Fixed return investments are most attractive in nature when interest rates are falling.

Moreover in addition to having too many dollars in circulation, inflation can also be increased by a drop in the value of the dollar in foreign exchange markets. The main cause of the dollars recent drop is perceptions of its decreased value due to continuing national deficits and trade imbalances. Foreign goods, because of this, can become more expensive. This would make US products more attractive in nature abroad and improve the US trade balance. Though, if before that happens, foreign investors are perceived as finding US dollar investments less attractive, putting less money into the US stock market, a liquidity problem can result in falling stock prices. Political turmoil as well as uncertainty can also cause the value of currencies to decrease and the value of hard commodities to increase. Commodity stocks do quite well especially in this environment.