How Interest Rates Can Affect the Stock Market Part 1

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The fluctuation of interest rates will alter the relationships between competing financial assets, of which the bond/equity market relationship is the most important. Investors are often deem to have a liking of investing either into stocks or bonds. If interest rates rise faster than dividends can increase, bonds will become more attractive and, at the margin level, money will flow out of stocks into bonds. Which means stocks will fall in value until there is a correlation or until the investors perceived the price to be more reasonable.

Of course not all shares will be affected by this correlation. The effect of interest rate changes will depend upon the yield obtained combined with the prospect for profit growth. The stocks that will be affected the most are preference shares and defensive Reits as they are held as much for their current dividend yields as for potential growth.

Companies which are in dynamic stage of growth are usually financed by corporate earnings and for this reason pay smaller dividends. These kind of stocks will be less affected.

Interest rates can also affect the stock market in many other different ways. They can have a direct or indirect influence on corporate profits which relates to the price investors are willing to pay for the stock. It can also affect margin debt which affects margin positions. I will explain more on this in Part 2 here.

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