Many of us are bewildered by the appreciation of the stock market, because the overall economy does not seem to be doing that well. The great exceptions are real estate and car sales, but that’s mainly due to record low interest rates.
As we witness the market going up and up, the obvious question is: Will anything derail it? Yes, there is something, and it’s called rising interest rates.
Why Interest Rates Will Rise!
The Federal Reserve is keeping interest rates super low through a massive program of buying bonds. They are printing money to buy these bonds, and this extra liquidity is the oil that is making the economy grow, as well as the fuel that is propelling the stock market to great heights.
Will this bond buying program go on forever? No, the Fed has told us that they will put an end to it when either inflation accelerates beyond 2% or the unemployment rate gets close to 6.5%. Inflation seems dead presently, but the unemployment picture is getting better each month. We have seen good numbers of jobs being created this year. If this momentum continues, and it should, it could encourage the Federal Reserve to slow down its purchase of bonds. What is the most likely consequence of this? Interest rates will rise–first, because, with lower demand for bonds, their prices should drop. This will raise interest rates, since they are inversely related to bond prices. The second consequence of the Fed slowing their bond buying spree is that it will confirm that the economy is growing. This will raise investor expectations, therefore demanding higher interest rates. How will all this affect stock prices?
How Will A Rise in Interest Rates Affect Stock Prices?
Let me illustrate this with an example. Assume you have an investment that will pay you $100 for the next 100 years. If you decided to sell it now, how much could you get for it? The math is simple. Take the $100 and divide it by your required rate of return. Let’s assume that this is equal to what you could earn by investing in a 10 year Treasury bond. Today it closed at 1.81%. Your investment would then be worth $5,525 ($100 / 0.0181).
Fast forward two years. Suppose that the same Treasury bond is now paying 4% as a result of the previous argument. What would happen to the value of your investment? Take the same $100 of income, but this time divide by 4%. You get $2,500 ($100 / 0.04). In sum, the value of your investment dropped to $2,500 from $5,525. WOW! That’s the impact of interest rates on values, and that gives you an idea of how rising interest rates will affect stock prices.
A Black Swan or the Unlikely but Possible Negative Event
Are there other unlikely yet possible events that could topple this stock market? Of course there are many, but here are two I’ve been considering lately. China’s economy could slow down or have a major bankruptcy. After all, business cycles do occur. While China has been on the upswing for over 30 years, they could also face a recession. Why not? That would throw the world into a major recession.
The second event that worries me currently is war in the Middle East. Syria, Iran, Israel, Hezbollah, and so many others in that part of the world, have their weapons drawn. That could explode at any moment, with serious implications for us all.
In sum, for those of you close to retirement, or presently in retirement, preservation of capital should be the number one investment objective. In today’s economy, this means keeping an eye on interest rates. As I write this, the 10 year Treasury is at 1.81%. If it moves beyond 2.25% in the next few months, stock prices are likely to take a big hit. And you and I know that interest rates have to increase at some point; they cannot be kept artificially low forever.
As usual, I encourage you to meet with me to review your personal finances. To set up an appointment, just reply to this email or call me directly at 714.771.6000.