I have said it in the past. I am a lover of academia! Why, because it is the foundation for everything that we do, from valuing the stock market, to balancing our check books. This is why I am a fan of Jeremy Siegel, Ph.D.
Jeremy Siegel takes us through the current bond market and how interest rates have risen in the last year, not just in the U.S., but in Europe, the UK and even Japan.
He even shows us how we are to price financial assets, whether through D.C.F. or Cap Rates. "The discount rate is dependent on two factors: the rate of interest on safe bonds (such as U.S. government bonds) plus a ÃƒÂ¢Ã¢â€šÂ¬Ã…â€œrisk premiumÃƒÂ¢Ã¢â€šÂ¬Ã‚Â to compensate for the possibility that the future cash flows will not be paid as expected. The interest rate in turn is composed of two parts: one part to compensate bondholders for inflation, and the other, called the real rate, which is linked to productivity and growth."
The bond market, of course, suffers the most from the increase in rates since the cash flows of bonds, namely the coupon payments, are fixed in contractual terms and do not respond to the stronger economic outlook.
In the Stock Market, higher growth means higher profits and therefore higher cash flows. But the rise in interest rates also increases the rate at which these higher cash flows are discounted, which has a negative impact on the price. Stocks have in fact been volatile with no clear direction since rates have risen.
Real estate falls between stocks and bonds. The rise in interest rates increases the cap rate, which is the name given to the rate at which future rental income is discounted and this lowers real estate prices. But a stronger economy allows for higher rents, particularly for commercial and industrial real estate, which partially offsets the rise in the cap rate.
Jeremy Siegel believes that in this environment equities will hold up the best, with real estate lagging, and bonds, especially those issued by highly leveraged firms, faring worst.