Pete Wargent blogspot

CEO AllenWargent Property Buyers, & WargentAdvisory (institutional). 6 x finance author.

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Sunday, 22 March 2015

Interest rates and stock markets

Stock market records tumbling

I noted here on Friday that Aussie share indices had zipped to a fresh 7 year high.

Despite headwinds for the economy this may not be entirely unexpected, for other things being equal lower interest rates can encourage higher stock prices.

In part this is because lower interest repayments on business loans can improve earnings (and theoretically the value of a company is the sum of all future cash flows discounted back to a present value), while businesses can further opt to finance and thus catalyse expansion using a cheaper cost of capital.

Meanwhile lower interest rates might also reduce the "risk free return" thus impacting investor behaviour.

On the flip side, interest rates tend to be cut when demand is weak or the economy is at risk of stagnating, so investors do need to be cognisant of potential downside risks. 

Unusual times

We are living through unusual times, with so-termed "quantitative easing" in some countries adding a new dimension to investor behaviour.

It has been a calamitous six or seven years for catastrophic thinkers who have opted to sit out of the markets and to wait for a crash before investing (or short the major financials) - basically guessing at what the forever unpredictable markets might do next - which is no kind of investment plan.

The Dow Jones (DJIA), for example, has soared from close to 6,500 at its financial crisis nadir in March 2009 to above 18,000 today. Ouch.

Further the NASQAQ - which is heavily weighted towards technology and internet stocks - has ripped through 5,000 after an incredible run as charted below, the index value easily tripling and more since its November 2008 nadir.

The NASDAQ composite has now breached a 15 year high and sits mightily close to its "tech bubble" peak of 10 March 2000 (when the index hit an extraordinary intra-day high of 5,132 before collapsing to just 1,423 by the third week of September 2001).

Meanwhile back in the Old Dart those "FTSE 7000" T-Shirts have been in cold storage for a heck of a long time, but the London index has finally cracked this testing psychological barrier. The FTSE 100 index notched its highest ever close of 7,022.51 on Friday. 

It is important to recognise here that  although the UK's premier index appears to have done very little since the turn of the century, in accumulation terms (inclusive of dividends) returns have been solid.

Value now hard to find

There are endless potential approaches to share market investing.

One such is the "value investing" approach of buying shares in outstanding companies when market price-earnings ratios are depressed and average dividend yields are elevated. 

Over time as the market reverts to the mean, share prices will eventually rebound higher again while the investor continues to benefit from the tax-advantaged dividend streams from a portfolio of wonderful businesses.

Broadly speaking from 2009 onwards there were some excellent opportunities for value investors to buy shares in wonderful companies at mouth-watering prices.

However, in many cases valuations are now becoming stretched, and for most investors a different approach is likely to be needed at the present time.

One of the countless alternative approaches is simply to deploy the same amount of money into the market index monthly or quarterly come rain or shine, known as averaging.

How long the current bull markets run for is anyone's guess - but the risk of a sharp correction by definition must be rising.

The more an investment plan relies on the market moving in your favour over a short time horizon, the greater the risk of sub-optimal results!