So what gives? Why did the stock market go up yesterday even though interest rates rose? It’s simply that the news about the Fed’s interest rate hike was already priced into the market. What does that mean? It refers to a well known (if you studied finance, that is) investment theory, widely known as the efficient market hypothesis (“EMH”).
EMH originated largely from research by Eugene Fama’s. Fama, a Nobel laureate in economic sciences, a professor at the University of Chicago Booth School of Business, and widely recognized as the "father of modern finance," wrote a book that was published in 1970. That book is “Efficient Capital Markets: A Review of Theory and Empirical Work.”
Fama put forth the basic idea that it is virtually impossible to consistently ‘beat the market.’ That is, to achieve better returns by investing in individual stocks than one would earn by investing in the overall stock market (as reflected by major stock indexes such as the S&P 500).
If you don’t know of Fama, you may know of Burton Malkiel. He is also an academic (he is a professor of economics at Princeton University and is a leading proponent of EMH but unlike Fama, his most classic book, A Random Walk Down Wall Street, has been read by millions of people (and is also one of Financial Poise’s list of 15 best books for beginning investors).
Yesterday's rate hike was predictable given that the latest Consumer Price Index was released last Friday and it showed that that inflation soared in May. As noted above, the markets have been down since then. According to EMH, the reason the market did not go down yesterday is that although the Fed's announcement was yesterday, the news of the announcement was already priced into the market. In yesterday's case, however, another force was also at play: the market essentially reacted well to the the Fed's proactive response to inflation and the clear guidance it provided as to its policy intentions.
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