The Dark Side Of A Rising Stock Market

In the calculations underlying the exhibit below, the discount rate is assumed to fall 0.167% each year, so that over the course of 12 years it drops to 5.00% from 7.00%. Using that assumption, the exhibit plots as the green line what the returns would be on a typical stock during and following period of declining discount rates. The exhibit shows that during the 12 years when the discount rate is falling the return on the hypothetical stock is over 10.50% per year. But once the discount rate stops declining, future returns drop to 5%, less than the 7% that would have been expected prior to the drop in the discount rate.

The reason for the high observed returns during the period of declining discount rates is a rising price for the hypothetical stock. The second exhibit below plots the price of the stock compared to what it would have been with no change in the discount rate. Remember in these calculations, nothing changes except the discount rate. The exhibit shows the sharp rise in the stock price due to the falling discount rate.

 There are two dark sides to a rise in the market associated with falling discount rates. The first is that once the drop is over expected returns on stocks going forward are lower. There is reason to believe this is where we are now. The second is that what goes down can rise again. If investor fears were to increase and discount rates were to rise, the process could reverse itself leading to a sharp drop in stock prices as shown in the final exhibit.

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Disclaimer: Cornell Capital Group LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or ...

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