Ben Bernake, Chairman of the Federal Reserve, was saying that by easing up on bond buying they would be easing off the accelerator rather than hitting the brakes on the economy. Despite these assurances, the market has tanked, wiping out returns from June and May in two days. The trouble is that the stock market trades on the acceleration of the economy rather than the velocity. Changing interest rates may only effect earnings growth slightly, but this can have a big effect on the stock market which prices stocks based on expected future earnings.
In physics the rate of change in distance per unit time is velocity. If you drive 50 miles in one hour, you have a velocity of fifty miles per hour. The rate at which velocity changes is acceleration. For example, something falling will go from zero feet per second to 32 feet per second over the period of a second, so the acceleration due to gravity is 32 feet per second per second, or 32 ft/s^2. The rate at which the acceleration is changing is called “the jerk.”
A stock will be priced based on the expected future return of a stock. This means that if earnings are expected to increase, the price will increase. It is the rate of change, rather than the actual earnings, that causes the price to change. The change in price occurs as soon as the earnings increase is expected and then generally will stay at the same price range with minor fluctuations due to trading and other factors so long as the earnings expectation remains the same. Earnings are the rate at which money is produced, which is like the rate at which a distance is covered. It is therefore like the velocity of money.
The rate of earnings growth is then like the change in velocity, or the acceleration. A stock will be priced based on the rate of earnings growth. If growth rate changes, the price will change as well. A price change will occur rapidly when the jerk is non-zero – when the rate of growth of earnings changes.
This is why we are seeing the stock market swoon despite Bernake’s assurances that they are just easing off the accelerator. People know that interest rates will increase when that happens. That will make money harder to get and make companies pay more to borrow money. Both will cause earnings growth rates – acceleration – to slow. The jerk is therefore negative, so the markets have reacted negatively.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.