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I was recently told that stock markets in the US and EU has boomed as a result of quantitative easing, where the central banks has bought bonds with longer maturity to push the prices higher and consequently lowering those yields. Due to the lower yields on long maturities investors turn to other investments (primarily stocks) to achieve better returns, thus pushing prices higher as demand increases.

From a macro-economical perspective this I find this understandable, but from a more fundamental perspective I can't seem to find any logic in this. Say the prices should reflect the true value of the firms, is there any reason to why the "value of the firm" (considering the whole market as one) should increase faster as a result of the actions of the central banks? (Assuming this as actually the case. By quickly approximating the geometric means since after the financial crisis yields a return of roughly 18% per year, of course the lowest point from where I'm calculating the market might have been somewhat undervalued.. but still, it seems a bit higher than "usual".)

Of course there is the obvious explanation that banks can borrow money more cheaply and perhaps companies can more easily invest in new projects from debt financing etc. But should that really make that big of a difference?

I'm not sure if this is the appropriate forum to ask this question. I hope so!

closed as off-topic by ChrisInEdmonton, Dheer, John Bensin, JTP - Apologise to Monica May 7 '14 at 18:55

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  • Just put more money flowing around in the market and less of the goods to buy, primarily basic economics of supply and demand. Of course there is the obvious explanation that banks can borrow money more cheaply and perhaps companies can more easily invest in new projects from debt financing etc. But should that really make that big of a difference? Yes, that is the basic premise of macroeconomics equation Y = C + I + G + NX. – DumbCoder May 7 '14 at 16:37
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There's a premium or discount for various stocks subject to influence by the alternatives available to investors, meaning investments are susceptible to the principle of supply and demand.

This is easily seen when industries or business models get hot, and everybody wants a tech company, a social media company, or a solar company in his portfolio. You'll see bubbles like the dotcom bubble, the RE bubble, etc., as people start to think that the industry and not its performance are all that matters. The stock price of a desired industry or company is inflated beyond what might otherwise be expected, to accommodate the premium that the investment can demand.

So if bonds become uniformly less attractive in terms of returns, and certain institutional investors are largely obliged to continue purchasing them anyway, then flexible investors will need to look elsewhere. As more people want to buy stocks, the price rises. Supply and demand is sometimes so elementary it feels nearly counter-intuitive, but it applies here as elsewhere.

  • Note that this is not an endorsement of QE, just an analysis. Long-term effects and policy implications are a separate issue. – NL7 May 7 '14 at 14:08

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