It’s going to be tough for the S&P to break above its present range. Last month we saw the equity market show extreme sensitivity to news from the Federal Reserve. It rallied when the Fed indicated that the economy was too weak to permit a cut in interest rates. Why should that be the case? There is actually a simple arithmetic answer to this question (although equity investors may be sorry they asked).
At extremely low interest rates, stocks are extremely sensitive to changes in the discount rate. If the stock price is equal to e(P)/r, that is, expected earnings over a discount rate, very strange things can happen when both the numerator (expected earnings) and the denominator (the discount rate) are extremely low.
Much as I dislike the old Dividend Discount Model, it is useful for comparative statics (what happens when to one variable, in this case the price of the S&P 500, when we change another variable, namely the risk-free rate).
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