A rational investor will weigh the risk of any investment against the price he will pay, valuing promised future growth and income against the likelihood it will be received.

This is a "time value of money" problem. Earlier in the shares FAQ (in the equity valuation section) I have explained the concept of "discounting".

Read that section again, there is something you really need to understand. Securities are valued according to an "expected return" or required return. When interest rates (and inflation) are low, investors will not require as high a gain to justify the risk they are taking. The discounting factor is the market's way of adjusting the required rate of return, a heavy fall in prices is the market's way of saying "given the latest info, we're now only going to pay this much for the future cash flows of this investment".

Clearly when interest rates are high, the market will discount stocks in such a way that the return they give is acceptable compared to "low risk" interest bearing investments. On the (rather feeble) assumption that the market is omniscient and has assessed the future cash flows with perfect accuracy, a set of cash flows discounted by 10% will give you a 10% return, cash flows discounted by 20% will give a 20% return.

In addition, the market receives an extra "one-off" boost from a change in interest rates. If rates are lowered from 20% to 10%, prices will more-or-less double immediately so the future return will be only 10%. This means a sharp rise in general prices, followed by a rather ordinary return.

The opposite occurs of course if interest rates rise. If interest rates rise, prices will immediately fall, but the returns following that will improve, maintaining (in theory at least) the same risk premium to basic interest rates as before, but as interest rates are higher the nominal return will be higher.

A rise or drop in interest rates is a "one-off" event, having (theoretically) immediate effects on markets. Of course there can be many consecutive rises and falls in interest rates, which will trigger a series of falls or rises on the stock market. If you look at the trend in interest rates since 1990, you can probably get a fairly good idea about why the stock market had such a good run throughout the 1990s, again and again rates were lowered, from a peak in 1990 to lows that are continuing even now (November 2001, following the shock to the market and economy following the terrorist attacks on New York interest rates have gone down again, treasury bill yields are skirting the 4% mark. As an aside though, although everyone is blaming the terrorists for the waning economy, all the indicators showed a rather sick financial system in the months before this incident, and there had been a fairly clear bear market going for a long time prior to September 11).

Of course this has ominous implications for the future course of the market. Investors are now used to seeing returns in the 10-30% range, looking back at the startling returns during the 1990s. In order to maintain that sort of return either corporate profits will have to go through the roof, or interest rates will need to fall a lot, and continue falling in order to sustain these rises.

Of course if interest rates suddenly rose to 20%, those that buy in after the crash this causes will then enjoy a 20% or better profit from that point on.

Ok, it is fairly clear that interest rates move securities prices (shares, bonds and real estate all alike), what causes interest rates to fluctuate?

This is a complex problem in economics but to give a simplistic half-right answer, economists change interest rates to control the supply of money, they raise interest rates to cut down on credit and slow the economy, which is an attempt to prevent inflation from running riot because high growth and high demand are leading to labour and materials shortages. They lower interest rates because demand for goods and labour have slackened and need stimulating, as happens in a recessionary environment when unemployment is high and production is low.

That last paragraph of course also backs up the "buy in gloom, sell in boom" cliche, an overheating economy is an economy where growth is extremely high and everyone is fully employed, with wages increasing and goods becoming more expensive - in short, a boom. A recessionary economy is a time when steps are going to be taken to stimulate things, and one of these steps is dropping interest rates.