The Long-Term Implications of Today's Dow Drop

In the context of the 2,700-point advance we've seen in the Dow Jones Industrials (DJINDICES: ^DJI  ) since this time last year, this morning's 150-point drop is only a minor pullback. But substantial declines in bond markets around the world point to more than just a one-day event, instead reflecting the increasing concerns about the impact that the inevitable end of the Federal Reserve's quantitative-easing program will have on the financial markets. Given the extent to which the global economy has relied on low interest rates in the U.S. and elsewhere to drive its recovery attempts, the sharp upturn we've seen in bond rates has long-term implications for stocks both in the U.S. and around the world.

A look at the stocks that are leading the Dow lower today reveals the contribution higher interest rates have made to the overall market's declines. Despite strong consumer confidence, you'll find consumer giants McDonald's (NYSE: MCD  ) , Johnson & Johnson (NYSE: JNJ  ) , and Coca-Cola (NYSE: KO  ) all among the worst performers in the Dow today, with losses of more than 2%. Ordinarily, you'd expect these defensively oriented stocks to perform well in a downturn, as their businesses enjoy largely stable demand from loyal customers who rely on having those products regardless of economic conditions.

One way of explaining the disparity is to consider these stocks on a valuation basis. Lately, all three have seen their valuations vaulted higher, with Coke and J&J fetching more than 20 times trailing earnings and McDonald's weighing in with a multiple of almost 19. Those high valuations are reasonable in light of the rock-bottom interest rates that have prevailed for several years, pushing investors who would ordinarily prefer fixed-income investments into the stock market. But as interest rates rise, the bond-like flows of dividend payments that these secure stocks provide decline in value, therefore in many ways these stocks may well track the bond market in the absence of company-specific news to the contrary.

Interestingly, on the other side of the coin, Bank of America (NYSE: BAC  ) is one of the best performers today, gaining about 0.7%. Banks are sensitive to interest rates, but they can actually benefit from rising rates if the majority of the rate increases appear in long-term rates. A steepening yield curve can expand net interest margins and bolster overall earnings, and although higher rates also have a dampening effect on mortgage-refinancing activity and other important sources of revenue for banks, the overall impact isn't always so negative as you'd think.

Keep your eyes on rates
Stock investors aren't used to watching the bond market, but until the Fed's future course becomes clear, you'll want to pay attention to bonds. Otherwise, the moves you see in certain high-quality stocks won't always make sense.

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  • Report this Comment On May 29, 2013, at 12:13 PM, tjsimone wrote:

    The stock market goes up, and the stock markes goes down, no? Why did it go up yesterday? The Fed news was already out.....Its amaing how everyone tries to do a minute by minute blow as to why the market is where it is...newsflash...at some point in the next year, you will be both right, and wrong about this article. I thought the Motley Fool preached about the long term.

  • Report this Comment On May 29, 2013, at 12:29 PM, sanoran wrote:

    bin-Bernanke is kept in power by the Banks, Bernanke is not elected by US Citizens. So, Bernanke has an obligation to make the Banks make money. Bernanke printed lots of cash and gave it to the 'Prime Dealer' Banks, who manipulated the market and dumped on the masses. They have made their money. Now US Citizens are left holding expensive stocks and houses, which they bought on credit (which the Banks gave with Bernanke-bucks).

    Bernanke cannot solve America's problems,.... economists don't produce a single cent in wealth. All Bernanke can do is trick citizens into allowing Banks to rape them. Which is what Bernanke did :)

    Yellen, also from Israel, is loved by the Banks.

    US Citizens, living in the illusion of democracy, have no say in deciding who is in charge of the money printing and distribution.

  • Report this Comment On May 29, 2013, at 12:39 PM, pl2358 wrote:

    Umm....

    You make the statement,

    "But as interest rates rise, the bond-like flows of dividend payments that these secure stocks provide decline in value, therefore in many ways these stocks may well track the bond market in the absence of company-specific news to the contrary."

    That statement, in reference to the specific stocks mentioned, as well as a number of other 'widows and orphans' stocks, is absolutely incorrect.

    If KO raises it's dividend each year at a rate higher than the rate of inflation (and it has over the history of the stock's existence), then the dividend far outperforms bonds.

    A bond's interest payment doesn't go up. You get the same $50 every year on a $1,000 bond that pays 5%, regardless of what the price of the bond does. A bond's interest payment doesn't go up, unless it's written into the contract. Most bonds don't have escalating interest rates.

    While the bond's interest rate is eaten away by inflation, the fact that KO raises it's dividend each year faster than the increase in the rate of inflation means that KO's dividend is BEATING inflation, while the bond's interest is LOSING to inflation. And, no matter what, at the end of the life of the bond, you only get your $1,000 back. At least you have the option, and likely outcome, that the KO stock will have increased over the time you've held it (unless they spring New Coke on us again.)

    KO's dividend does not decline in value. It not only goes up every year, it also beats inflation. Please get the facts straight when comparing stocks like this to bonds. KO is not even close to a bond and will not perform like a bond. It's losing money today and across the last few days because it's gotten ahead of itself in price, and it's seeing it's correction that is due.

  • Report this Comment On May 29, 2013, at 7:57 PM, NickD wrote:

    KO is 20% of my net worth.

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