Key Points

• Stock prices going up is bad, stock prices going down is good, but it’s important to understand how money flows in order to be on the right side of the trade.
• US Federal Reserve Interest Rate Policy has the most significant impact on stock prices.
• Follow the Big Money Managers and Don’t Fight the Fed.

We’ve previously discussed the concept of Market Sentiment and the effect on stock prices. We noted the following

• ‘The Crowd’ determines the price of a stock
• Sentiment determines the ‘Premium’ above ‘Book Value’ of a company
• Positive Sentiment stimulates ‘Buying’ demand and negative Sentiment stimulates ‘Selling’ supply.
• Extremes in Sentiment often mark the end of a trend
• The greatest profits are made by entering/exiting the market at the extremes which often means taking a position which is opposite to the crowd at those extremes.

In this stockmarketHQ Strategy article we’ll discuss why stock prices move up and down and integrate the effect of interest rate increases on stock prices.

At stockmarketHQ we follow a simple money philosophy.

There is a $34 Trillion pile of money in the stock market. Each month, Pension funds and individual investors put more money into the pile and the pile gets bigger. Stock prices go up. All you have to do is put your hand in the pile and take some. If you don’t, then someone else will. Stock prices go down.

Digging a little deeper into that concept and applying it to why stock prices move up and down.

Picture a big pile of available money on the sidelines. That money has to be invested in something to provide a Rate of Return and it will seek out the opportunity which provides the greatest profit potential.

Big Money Managers. They have the biggest pile of money and have teams of financial analysts and market technicians which identifies a company with profit potential. This can mean it is undervalued relative to its peers or the broader market, has an upcoming product initiative, maybe there is a geopolitical event, or maybe an earnings report. The Big Money managers start to take money out of their (big) pile on the sidelines and put it into the stock. They will generally put about 3-5% of their portfolio value into a stock. This increases the stock price and as the price moves away from their initial ‘buy price’ or they reach their 3-5% limit, they stop putting money in. BUT that is generally when they start going on TV/media and start disclosing headlines such as ‘Best stock to own as oil prices rise’, or issuing ‘Analyst Upgrades’ on the company.

The Sentiment becomes more Bullish.

Small Firms or Professional Investors. They have the medium sized pile of money, no financial analysts or market technicians, and generally start buying after they see the Big Money Managers buying. Effectively, they follow the trend and start to take money out of their (medium) pile on the sidelines and put it into the stock. The stock price goes up. They continue until they either reach their 3-5% allocation limit or the price moves too far away from their initial ‘buy price’, then they ‘ride the trend’ upwards.

The Sentiment becomes increasingly more Bullish.

Retail Investors. They have the smallest pile of money and rely on making investment decisions based on media articles or stock market commentators on Business TV. They see that stock XYZ has gone up substantially so therefore it should keep going up. They take money out of their (small) pile on the sidelines and put it into the stock. The stock price goes up. They continue until their (small) pile of money is empty.

The Sentiment reaches an extreme. Recall from above. Extremes in sentiment often mark the end of a trend and the greatest profits are made by entering/exiting at the extremes.

The stock price stops going up. The original pile of money on the sidelines is now fully invested. For the stock price to continue higher, there has to be NEW money coming from somewhere.

The process reverses.

Big Money Managers – Their teams of Financial Analysts and Market Technicians now determine that the company is overvalued.  Big Money Managers start to take money out of the stock, slowly, at a rate about equal to the amount that the Retail Investor is putting money into the market so that the stock price only declines at a slow rate. BUT, that money then goes into the Big Money Managers pile of money on the sidelines, and that pile of money gets bigger. Then they go on TV and say ‘sell this oil stock on demand destruction concerns’ and issue ‘Analyst Downgrades’.

The Sentiment becomes Bearish.

Small Firms or Professional Investors – see that the trend has ended. They start to sell and they put that money into their pile on the sidelines. Their pile gets bigger. The stock price drops and they might even ‘Short Sell’ the stock in order to profit as price decreases. that is, they want stock prices to decline.

The Sentiment becomes increasingly Bearish.

Retail Investors – Either hold on in the hope that prices will return back to their break even cost or sell at a loss and moves that money to the sidelines in the hopes of buying it back cheaper.

The Sentiment reaches an extreme. Recall from above. Extremes in sentiment often mark the end of a trend and the greatest profits are made by entering/exiting at the extremes.

The stock price stops going down. The original pile of money that was fully invested is now fully on the sidelines. For the stock price to continue lower, there has to be NEW sellers coming from somewhere.

The process reverses.

BUT that process doesn’t necessarily reverse into the same stock. Money always rotates between sectors and even investment ‘Themes’ in its effort to seek out the greatest profit potential.

THE EFFECT OF INTEREST RATES

The biggest contributor to the financial system, and the stock market, is the US Federal Reserve. They effectively control how much money is in the system, or how big the pile of money is allowed to get. They do this through controlling Interest rates and Bond buying.

As interest rates decrease, or when they are low, the US Federal Reserve is allowing more money to be put into the financial system. The pile of money gets bigger.  Big Money Managers will borrow money at the low interest rate which makes their pile bigger and they can put that ‘NEW’ money into the stock market. Prices go up higher than a company would normally be valued at.

As Interest rates increase, or when they are high, the US Federal Reserve is effectively reducing the amount of money that is being allowed in the financial system. The pile of money gets smaller. When interest rates are higher than the Rate of Return that Big Money Manager can earn, they take money out of the stock market. Prices go down lower than a company would normally be valued at.

What does all that mean at stockmarketHQ

Stocks prices going up is bad – As ‘the Sentiment’ becomes increasingly more Bullish, ‘the Crowd’ commits more and more money out of their pile of money to a stock. The pile of money gets smaller and the supply of new capital which can be invested decreases. When all of the market players are fully invested and Sentiment is the most Bullish, is when the pile of money is the smallest. This is when the stock ‘TOPS’ and starts to reverse.

Stock prices going down is good – As ‘the Sentiment’ becomes increasingly more Bearish, ‘the Crowd’ withdraws more and more money out of the stock and puts it back into their pile. The pile of money gets bigger and the supply of new capital which can be invested increases. When all the market players who would sell, have sold, and Sentiment is the most Bearish is when the pile of money is the biggest. This is when the stock ‘BOTTOMS’ and starts to reverse.

Understanding how money flows can help investors and traders stay on the right side of the trade.

Once the money has moved to the sidelines, the question becomes ‘where will it rotate to next?’ The answer – where the Big Money Managers see the greatest potential for profit. Everybody else will follow.

Interest rates going up is bad for markets. Interest rates going down is good for markets.

The market will reach a new high when interest rates are low. The market will decline as interest rates increase. The market can not reach the previous highs as interest rates increase because the US Federal Reserve is making the pile of money available in the market ‘smaller’.

“Don’t Fight the Fed” is a well established axiom of investing philosophy.