Stock values and why they change

From 2000 through 2002, bonds outperformed stocks every year -- a historic "three-peat" that hadn't been seen in the modern investment era that began in 1929.

While the stock market often seems to behave like a manic-depressive who's been off his medication, in fact it's quite rational most of the time.

Information about the economy and the prospects of specific companies comes in, and the market reacts. Sometimes those reactions are extreme, but they usually sift down to a handful of causes.

So why does the market seem so erratic? Because life in general is unpredictable. A war here, a hurricane there. These things can occur without much warning, having effects on the economy that no one could anticipate.

What's harder to explain is why the market can ignore obvious problems for a long time and then suddenly overreact. Here's one explanation: Investors have a hard time gauging the magnitude of problems.

But if you ignore the occasional surprises that roil the market and focus instead on its long-term behavior, you'll find corporate earnings and interest rates are key.

Earnings growth

Over periods of five years or more, stock prices closely track corporate profit growth. The longer the stretch of time, the more important earnings trends are. Indeed, since World War II, an estimated 90% of the stock market's gain has come from profit growth. As profits add up over time, the scale tips and prices rise, regardless of how investors have voted in any given day, month or year.

Interest rates

In the short run, changes in interest rates can be more important than earnings. When rates go up, all other things being equal, investors tend to pull money out of stocks and put it into bonds and other fixed-income investments because the returns there are so attractive.

That brings stock prices down, and sends bond prices higher. On the other hand, when interest rates come down again, once more with other things equal, then investors tend to shift money into stocks, reversing the previous trend.

Note, however, that the operative phrase above is "other things equal." In real life, other things are rarely equal, and so this relationship -- while true in general terms -- is hardly perfect.

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