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The American President’s first comment on the 7% fall of US shares prices earlier this week, having taken credit almost daily over the past year for its rise, was a magnificent piece of Trumpery.

He tweeted: “In the “old days,” when good news was reported, the Stock Market would go up. Today, when good news is reported, the Stock Market goes down. Big mistake, and we have so much good (great) news about the economy!”

It’s hard to know where to start with this effort, so packed with clangers is it, but it’s a good place to begin today’s analysis of what happened this week.

For a start, he seems to be accusing the stock market of both treason and stupidity, which is novel, not to mention a touch of the pot calling the kettle black!

The “old days” were actually the past 18 months, when markets felt able to relax about what the Fed might do because inflation was comatose, and the best game in town was shorting Vix, because markets were calm and volatility kept fading.

Before that, and for as long as I can remember, the stock market went down when there was good news, because share traders were more focused on monetary policy than economic growth.

I’ve never seen this properly explained, but here’s a go.

I’d say it’s because companies tell analysts what their future earnings will be, so they are pretty confident about that, but central banks don’t, or can’t, give them same “guidance” about interest rates. The Fed has the “dot plot”, which are the interest rate forecast of each member of the Federal Open Market Committee, but these don’t seem to be believed for some reason and the Fed futures market is quite different from the average of the dot plots.

Share prices are the multiplication of future earnings by a discount rate, or interest rate, that is relevant to each firm’s risk profile. And for this process, the bond market is the key to everything.

Why? Because analysts use the US 10-year bond yield as the foundation stone for the discount rate, to calculate the present value of future cash flows. They add a “risk premium” to what they call the “risk free rate”, which is the 10-year bond yield, according to their assessment of how much riskier that particular security is than a bond backed by the American Treasury – which is supposed to be the least risky thing in the world to own, in fact it is assumed to be “risk-free”.

So I think share prices are more sensitive to interest rates than earnings growth for the simple reason that interest rates are more opaque and less predictable. Analysts and investors are therefore more inclined to react to them, sometimes violently.

To see more of Alan Kohler visit The Constant Investor for his Weekly Overview, exclusive stock tips, investment ideas, podcasts and much more. Click here to learn more.

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The Constant Investor is the new home of Alan Kohler, founder of Eureka Report and the ABC's finance presenter. Join to receive - Kohler's Weekly Overview, exclusive stock tips, investment ideas, podcasts and much more. Click here to learn more.



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