Why Do Markets Fall After ECB's Stimulus Package?

So Mario Draghi and his team at the ECB made their decision - the Quantitative Easing (QE) program will be increased to 80 billion Euros a month while interest rates have been cut by 10 basis points from -0.3% to -0.4%. And the markets responded well. Initially.

Eventually however, contrary to what a stimulus package should have entailed (and what my previous post focused on), the Euro strengthened while the stock market took a dip overall.

Why? Draghi made a staggering comment that halted the markets upward climb. He essentially pointed out that he did not anticipate any future rate cuts. Now, from my previous post, we know that company valuations are based off the expected future cash flows and interest rates. With the idea that future interest rates are almost certain to increase, valuations of stocks fall. A quick and simple formula to illustrate this is as follows:

P = ∑(CFn/(1+Rs)^n)

P: Price of 1 Share now

CFn: Expected Cash Flow in Year n

Rs: Cost of Equity (can also be Required rate of Return)

n: Number of Years from today

With interest rates as a denominator, an interest rate cut will increase valuations while a signal that increases the likelihood of future interest rates rising would lower valuations correspondingly. 

To Invest Or Not?

So where do we go from here? Seeing how jittery the markets have been recently, I feel that the sell-off was overdone. The market has speculatively priced in the problems of the future while forgoing the facts of today. The ECB has introduced a stronger stimulus package than ever before, increasing the QE program by 33% while decreasing deposit rates by 33%.

The stimulus package was introduced for its own namesake - to stimulate the market. Growth is what we should expect from the Eurozone, and the following months to come will show us the true effect of the ECB's latest monetary policy. In fact, the sell-off of the European markets provide us with opportunities to enter at a better bargain than before, and so perhaps now's a good time to start considering stocks with European exposure.

With that said, we should enter the market knowing the risks involved. Monetary policies do not directly improve economies. Monetary policies improve the factors available which enable economic growth. This ultimately means that the ECB's latest stimulus package might not have the same results as the good intentions that were attached to it. From this, we can either wait for more solid economic results to make our decisions and pay the higher prices to invest then, or accept the risks involved and invest at lower prices now. 

Whichever our choice, remember the core idea of investing - buy low, sell high. After all, who makes any money by investing when markets are at their strongest?