In this blog post, we’ll take a look at how earnings forecasts affect stock prices and the relationship between interest rates and stock prices. It may seem a little complicated at first, but once you get the gist of it, it’s not hard to understand.

Forecasts and expectations drive stock prices

A company’s earnings forecasts are always volatile. Even for the most established blue-chip companies, stock prices don’t always stay steady – some days they skyrocket, other days they plummet for no apparent reason. It’s not uncommon to see stock prices move by 10% or more in a single day. Why does this happen?
It’s because stock prices don’t just reflect current performance, they’re also a composite of expectations and predictions about the future. In particular, the market’s expectations about how a company will perform in the future play a crucial role in shaping stock prices.
So when new information comes in, or when existing information changes, investors reevaluate the future performance of a company, and that reassessment is immediately reflected in the stock price. As such, stock prices are heavily influenced by the psychological factors of expectations and forecasts.

The two pillars that influence earnings forecasts: macro and micro factors

So, what information influences a company’s future performance? We can divide it into two pillars: macro and micro factors.

Macro factors: economic trends and government policies

Macro factors are economic conditions, industry trends, government policies, etc. that go beyond a single company and affect entire industries or markets, not just specific companies.
For example, let’s say a government announces a policy to fully support the renewable energy industry. Companies in that industry will be more likely to receive subsidies and tax breaks, and will have a head start on technology development and export expansion. If a company was previously expected to sell 100,000 electric vehicles per year, but the new policy will allow them to sell 200,000 or more, their stock price will likely rise significantly.
Policy changes raise earnings expectations, and those expectations lead to higher stock prices.

Micro factors: individual company strategies and competitiveness

Micro factors, on the other hand, refer to internal changes within individual companies. These include business strategy, technology, product competitiveness, market share changes, and mergers and acquisitions (M&A).
For example, when a company announces that it has developed a breakthrough new technology or signed a strategic collaboration agreement with a global conglomerate, expectations for the company’s future performance rise and its stock price rises with it.
Ultimately, both macro and micro factors affect a company’s future performance, which in turn leads to the rise and fall of its stock price.

Key variables that have an immediate impact on stock prices: Interest rates

So what is the factor that has the most immediate and powerful impact on stock prices? The answer is interest rates.
While interest rates seem like a rather complicated concept, they basically refer to the rate of return an investor can expect when investing in a financial asset. For example, if you deposit $10 in the bank and it turns into $10.40 a year later, the interest rate is 4%.
But when we talk about “interest rates,” we’re not just talking about deposit rates; we’re referring to the expected return on any investment, whether it’s bonds, stocks, or real estate. The interest rate on each of these instruments depends on the risk level of the asset, and the riskier the asset, the higher the rate of return, and therefore the higher the interest rate demanded.

Key concepts in interest rates: required rate of return and risk-free rate of return

An essential concept to understand when it comes to interest rates is the required rate of return, which is the minimum rate of return an investor expects to receive when investing in a particular asset. If it doesn’t meet this standard, the asset loses its investment appeal.
The required rate of return is composed of two components

Risk-Free Rate:
The rate of return you would earn without any risk, typically based on a U.S. Treasury bond (10-year).

Risk Premium:
The additional return required based on the inherent degree of risk that an asset carries.

This can be expressed as a formula

Required Rate of Return = Risk-free Rate of Return + Risk Premium

For example, a bank deposit has a lower yield because it carries little risk of principal loss, whereas a corporate bond or stock will demand a higher rate of return because of the various risks involved. In this way, interest rates are the “reward” for the risk investors are willing to take.

Interest rates and stock prices move in opposite directions: Inverse correlation

The relationship between interest rates and stock prices is typically negatively correlated, meaning that when interest rates rise, stock prices tend to fall, and when interest rates fall, stock prices tend to rise.
This phenomenon can be explained by the Asset Pricing Model. When interest rates rise, the yields on safer assets like deposits and bonds increase, making it unnecessary to invest in stocks to take on the risk. This reduces the demand for stocks, causing stock prices to fall.
Conversely, when interest rates are lower, the yields on safe assets are lower, and investors move their money into the stock market where they can expect higher returns. As a result, stock prices rise.

Wrapping up: Stock prices are the result of forecasts, and interest rates are the basis for those forecasts

In conclusion, stock prices are the result of the market’s collective forecast of a company’s future performance, and interest rates are an important indicator that sets a baseline for that forecast. Policy changes, industry trends, individual company performance, and macro-financial factors such as interest rates are all factors that need to be taken into account to more accurately interpret stock price movements.
The stock market is always moving and changing, which is why you need insight to read the context and structure behind the numbers, not just look at them. As your understanding grows, so will your eye for the market.