This blog post explains the principle behind asset value decline simply, using the relationship between interest rates and stocks and the asset pricing model.

The Relationship Between Interest Rates and Stocks: Focusing on the Asset Pricing Model

One essential concept for deepening your understanding of the stock market is the asset pricing model. This model explains how we can calculate the price of an asset we invest in (typically meaning a specific stock or company). This calculation method also forms the basis for stock price formation.
A stock price is the result of converting future profits, based on a company’s projected performance, into present value. This principle is the core of the asset pricing model.
However, the CAPM is not simple. Estimating all possible future profits a company might generate is particularly complex and involves many subjective elements that can vary based on individual judgment. Therefore, investors must make a concerted effort to calculate and estimate logically and objectively, using all available information.

Present Value and Discount Rate

The process of converting all future income into its present-day value is called discounting. Those familiar with economics will recognize the term ‘discount rate’. The discount rate is generally determined by the investor’s expected required rate of return; the higher this rate, the lower the present value of future income becomes.
The required rate of return is calculated by adding risk to the base interest rate. This is closely linked to the determination of the price of capital and has an inverse relationship with the final price of an asset. That is, the higher the return investors demand, the lower the current value of the asset becomes.
Each investor has their own expected target rate of return. So, let’s examine how this required rate of return affects asset prices through a simple example.

The Relationship Between Required Rate of Return and Asset Price

Suppose you have $100 and want to make a one-year deposit at a bank. If the bank offers a fixed interest rate of 4%, you will receive $104 after one year. Since this exactly matches your expected return, you might choose to make the deposit.
But what if the bank only offers $102 after one year? The return rate is only 2%, falling short of your expected 4%. In this case, you would not make the deposit.
But what if the bank asks you this?

“We can give you $102 after one year. How much would you deposit now?”

This requires calculation. If your expected return is 4%, converting $102 in one year to present value gives approximately $98.08. Thus, if you deposit $98.08 now to receive $102 in one year, it meets your expected return, making the offer acceptable.
This principle clearly illustrates the essence of investing. If your required rate of return is fixed, knowing the future income you can earn allows you to calculate how much you should invest now. In other words, it’s converting future income into present value.
For example, if your required rate of return is 4%, the present value of $104 received one year later is $100. Conversely, the present value of $102 received one year later is $98.08. Thus, in situations with certain returns, the higher the required rate of return, the lower the current recognized asset value. This relationship is called an inverse relationship, or negative correlation.

Real-life example: Purchasing a tech device

Now, let’s apply this concept to a real-life investment decision. Suppose you plan to purchase a tech device and expect it to generate $100 in profit after one year of use. If your expected rate of return on this device is 10%, what would be a reasonable amount to pay for it today?
The correct answer is $100 ÷ 1.10 = $90.90. That is, investing $90.90 today to get $100 in one year yields a 10% return, meeting your expectation. However, if the device costs more than $90.90, the investment falls short of the expected return, making you reluctant to buy.
If the expected rate of return increases to 20%, the amount you’re willing to pay decreases to 100 ÷ 1.20 = $83.33. In other words, as the expected rate of return rises, the present value you accept becomes lower. This means that when future returns are the same, the higher the reward an investor demands, the less they are willing to pay now.

How are asset prices determined?

This leads to the final question: How are asset prices actually determined?
Ultimately, asset prices are determined by supply and demand. A price is formed when a balance point is found between those supplying the asset and those needing it. However, the required rate of return remains a crucial variable in this process. Generally, a higher required rate of return leads to a lower price, and a lower required rate of return leads to a higher price, maintaining an inverse relationship.

How is the required rate of return determined?

Why do required rates of return differ? Why do people say, “I need at least a 10% return” when investing in a particular asset? This benchmark is based on risk.
Naturally, higher risk demands greater compensation. Conversely, investors may accept lower returns for investments offering stable, predictable gains. Typically, investors set the US 10-year Treasury yield as the risk-free rate and add a risk premium based on the investment asset’s risk to derive the required rate of return.

The Relationship Between Interest Rate Hikes and Stock Price Declines

The reason global tech stocks plummeted immediately after the 2021 Lunar New Year holiday is also tied to this principle. The market anticipated U.S. interest rate hikes, and as the U.S. 10-year Treasury yield rose, the benchmark yield itself increased.
In this scenario, some funds that had intended to buy stocks shifted into bonds, reducing liquidity in the stock market and naturally causing stock prices to fall. Furthermore, when the benchmark yield rises, the required rate of return demanded by investors in the market also increases. However, if a company’s earnings or profit outlook remains unchanged, applying this higher required rate of return inevitably lowers the present value.
This phenomenon is particularly pronounced in growth stocks. Growth stocks, such as technology and science stocks, are often invested in with the expectation of high future returns. However, since these returns are mostly realized after a long period of time, the present value drops sharply as the discount rate increases. This multiplier effect further accelerates the decline in stock prices.

Various Factors Affecting Stock Prices

Interest rates are just one of many factors influencing stock prices. A nation’s monetary policy, international geopolitics, trade disputes, and events like wars or natural disasters all alter market expectations regarding a company’s future performance. Thus, stock prices reflect not merely a company’s current performance but the market’s comprehensive judgment about its future.
Furthermore, internal corporate conditions are also critical variables. Relationships with competitors, new product launches, internal management risks, or seemingly minor events like scandals involving major shareholders can significantly impact stock prices. This is because they undermine investor trust and expectations.

In Conclusion

A stock price is not just a simple number; it is an indicator reflecting the market’s complex expectations and psychology about the future. While it fluctuates in the short term with market trends, in the long term, a company’s intrinsic value and management capabilities are reflected in its stock price.
For novice investors just starting out, I hope you won’t be overly swayed by short-term stock price fluctuations. By building a solid foundation of knowledge and cultivating the ability to view macroeconomics and individual companies holistically, you can become a steadfast long-term investor.