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Federal Reserve Raised Short Term Interest Rates

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D. H. Taylor
(@dhtaylor)
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Joined: 2 years ago
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The Federal Reserve has raised short term interest rates by 50 basis points.  This is the first time in two decades that the Fed did a 50 basis point move upward.  The hope is that inflation is held at bay.  But, in a statement released by Federal Reserve Chairman Jerome Powell, he said that the Fed had not been considering a bigger increase in interest rates; he believed inflation would be contained.  And, with that, the stock market breathed a collective sigh of relief… and rallied some 1,000 points in one day.

I am going to break down what inflation looks like right now.  And, I am going to break down how a 50 basis point move looks for the future.  I will show that inflation is likely to be contained and that despite there being higher interest rates coming soon, the economy is quite strong and will move forward.


   
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brad clarke
(@bradclarke80gmail-com)
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Seems like the market called the feds bluff the day after the rally? What is your thoughts on that? 


   
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D. H. Taylor
(@dhtaylor)
Noble Member Admin
Joined: 2 years ago
Posts: 1053
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@bradclarke80gmail-com 

Hey Brad... generally, I think this is overblown.  But, there is a bit of merit to it.  

First, we have seen this before. Do a Google search on the term: Taper Tantrum.  When the Fed took us off Quantitative Easing back in 2013 - 2014, the market had fits just like a terrible 2-year-old. But, ultimately, the stock market went higher.  

Interest rates are the basis for how to value a stock.  If interest rates are at 1% then stocks will reflect that in their metrics for valuation.  If a stock yields a certain amount of EPS; perhaps $2.50 off of a $100.00 share price, or 2.5%, then that would be about correct with interest rates at that level.  But, interest rates are heading higher on the 10-year.  If the 10-year suddenly went to 5%, then the valuation of stocks would have to go higher along with interest rates.  That means that the same stock trading at 2.5% yield now needs to go down in order to give an investor a yield commensurate of the interest rate environment.  

But... that same stock is still only paying an investor the $2.50 annual earnings.  However, that $2.50 might need to move upward to 6% keeping it comparable to current interest rates.  That means that same stock would drop down to about $41.65 to pay a 6% EPS with $2.50.  Ouch.  That's a haircut.

But... revenues are going to increase during the future and, so will future EPS.  There will be an adjustment and a balance is struck in between the two pricings.  

Once that balance is "discovered", then stocks will start their long, slow move back upward.  But, I do not believe we see an extreme move upward very rapidly.  Ultra-low interest rates drove the stock market upward really quickly.  Interest rates getting back to normal will moderate the future moves higher in the stock market.  

The question becomes: How high with interest rates go?  I don't think we go to 5% in the 10-year any time soon.  Might take about 2 years.  That means stocks won't go downward as much.  

let me know if you have any other questions.  


   
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