© Manuel Balce Ceneta, AP

In October 2007, just before the crash, the stock market put on one last surge to new highs. Even though it was clear there were icebergs all around -- and indeed several ships were already taking on water and listing heavily -- the participants in the market decided to party One Last Time.

My excellent friend Peter Bennett, a money manager in London who has called most of the big market moves over the past 15 years, sent a missive to his clients with a powerful one-word headline: "Farce."

Well, here we are again. I am not so bold as to predict what is going to happen over the next few months, but the situation on Wall Street brings that word to mind yet again.

In the past two months bonds have slumped, long-term interest rates have surged, and yet the Dow Jones Industrial Average ($INDU) and the Standard & Poor's 500 Index ($INX) have been hitting new highs.


I don't offer crystal-ball gazing, hocus-pocus or any other associated magic or marketing shtick. I can only offer some basic math, basic common sense (I hope) and the perspective of someone who's first discipline was neither management nor science but history.

In a nutshell: Federal Reserve "tapering" -- the winding down of "quantitative easing," and the normalization of interest rates -- changes absolutely everything in the markets.

The bond markets already know this. The stock market doesn't. Investors need to understand the math. Most of them don't, and Wall Street isn't going to tell them.

So let's do the numbers, shall we?

As recently as May, as a result of the policies of the Federal Reserve, the basic interest rate which underpins financial markets -- the interest rate on the 10-year Treasury note -- was as low as 1.6%. Today it's already risen to 2.7%. Furthermore, history says the interest rate has typically fluctuated around 2% above inflation. Over time, that's what people who've been willing to own 10-year Treasury bonds have expected as an average return on their money. As the bond market currently predicts inflation of about 2.5% over the next decade, we can estimate that when the Fed stops rigging interest rates and they go completely back to normal, the rate on the 10-year would probably be around 4.5%.

Now let's look at what that means for stocks.

When you buy shares in the stock market, you are purchasing the right to a stream of dividends stretching out into the far distant future (forever, at least in theory). You're buying the right to all those lovely dividends from ExxonMobil (XOM) and General Electric (GE) and Wal-Mart (WMT) and Coca-Cola (KO) and Procter & Gamble (PG) and so on. Although you won't claim those dividends forever, because you aren't immortal, you can claim them for as long as you like. And when you no longer want any more you can sell the stock, with its claim on all the subsequent dividends, to someone else. And so on.

Imagine a share of stock that will pay you $100 in dividends every year for the next, say, 100 years. How much is that worth in today's money? How much would you pay for that stock? To know the value, you have to apply a relevant "discount rate" -- in layman's terms, and with some oversimplification, you have to know what interest rate you could get on the money if you didn't buy the stock.

In May, you knew you could earn 1.6% a year, at least for the next 10 years, if you left your money in 10-year Treasury notes. Applying a 1.6% discount rate to our stream of $100 dividends produces a value of $4,972. In other words, that's how much that theoretical stock would be worth, in today's money, if we use a discount rate of 1.6%.

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