Which of the following is least likely to explain a decline in the S&P 500 index:?

Which of the following is least likely to explain a decline in the S&P 500 index:

A) A decline in expected inflation. B) A decrease in expectations about corporate earnings. C) An increase in Treasury yields.

Equity market prices are positively related to expected earnings/cash flows and negatively related to discount rate. Discount rate is positively related to inflation expectations and treasury yields (risk-free rate).

I thought the inflation is high when the SP500 is high. However, the answer states that the dicount rate is positively related to inflation and they are lower when SP500 is higher. Can someone help explain?


I would mark A by discarding B and C.

B) If corporate earnings are low, then Stock Prices are low so SP500 index decreases.

C) If tresury yields increase, all interest rates in the economy increases, so all other bonds available in the market decrease in price. Investors will prefer to invest in bonds and decrease their investments in stocks. SP500 goes down.

I think about A

Inflation increases prices and reduces purchasing power of people. Consumption decreases when inflation increase and corporate earnings get lower then. Lower earnings, lower prices, lower SP500.

If inflation is expected to decrease, then consumption is about to rise (for a limited time until inflation rises again if production does not catch up the higher demand). Corporate earnings get higher and SP500 value get higher.

Another good explanation is the Kaplan’s answer about discount rate. Remember that a discount rate is the sum real real risk-free rates and risk premiums, one of them is inflation risk. So lower expected inflation, lower discount rates and higher stock prices, so higher SP500

Lower expected inflation lowers interest rates, which in turn raises equity prices.

Thanks for your help! Completely clear on this now.

OK. How then you explain low equity prices when nominal IR turn on negative? I mean deflation scenario.

I would vote for A. Higher inflation, higher demand for equity and real estates.

Why would I explain something that does not exist? Do you know what deflation means? Do you know the relationship between all three?

Second of all, you chose A, yet your explanation points to the opposite.

hahaha. I am popping some popcorn for this one…

Fixed that for you.

As MrSmart says, your rationale ended to be contrary of what choice you selected.

As I can see, low equity prices when real interest rates are negative it is an indication of severe recession and a strong willingness of the central bank to reduce nominal interest rates to the extent that real IR becomes negative. In such escenario, not only equity prices goes down, but also bonds, real estate, etc.

Whatever Mr. Smart says, in hyperinflation scenario real estate prices and stock prices rapidly grow.