Something unexpected happened on Wall Street on Thursday March the 4th.
The Dow closed down 346 points at 30,924; the S&P 500 closed down 46 points at 3,774; while the Nasdaq lost 275 points to close at 12,723. Overall, the S&P 500 is barely in positive territory at up 0.5%, and the Nasdaq is now down 1.3% on the year.
That isn’t supposed to happen.
If we take historical average returns of 10% a year since the stock markets started, then every month the markets should be up slightly more than 0.8% per month. So, the end of February should have seen YTD (year to date) gains of 1.6%.
Instead, the S&P is three times lower than that and the Nasdaq is in negative territory. What’s caused this?
Profit taking
According to Michael Hewson, chief market analyst at the trading platform CMC Markets UK, weaker oil and copper prices prompted some end-of-week profit-taking on the likes of BP, Royal Dutch Shell, Anglo American and Antofagasta.
This may have been a factor, but certainly, there are more factors at play here.
Bond Markets
Fed Chairman, Jerome Powell, was speaking at a Wall Street Journal event. Stocks began their slide following midday comments:
“Today we’re still a long way from our goals of maximum employment and inflation averaging 2% over time,” Powell said. The Fed chief added that the recent surge in bond yields “was something that was notable and caught my attention.”
The 'wait and see' message sent bond yields north and stocks south. In other words, the economic outlook looked uncertain to him. And let’s face it, if the Fed chairman doesn’t have a clue what’s going on, what’s the likelihood others know any better?
At times of uncertainty, people become interested in things that can offer certainty. Bonds is one such thing that offers that perceived certainty. Higher yields tend to cause investors to load up on bonds and dump stocks. When this coincides with a rise in interest rates (when bond yields provide higher returns), people don’t just become interested in bonds, people flock to bonds.
If you’re thinking of going into the stock markets, you should be familiar with some basic ideas.
Cash notes sitting under a mattress is only as useful as the face value of the note. So, cash in an (Islamic) savings account is better than cash under a mattress because it generates a return (though not significantly better as I have argued in previous articles). But the basic principle prevails: cash should be used to generate more cash.
There are many ways to generate more money. Stocks is just one. Putting it in an (Islamic) savings account is another. Buying bonds is another, and the list goes on. Depending on what’s available and the investor’s appetite, investors’ money will end up somewhere where more cash can be generated. Stocks is a great place to make your existing cash generate more cash. At the same time, though, the stock market is very risky; it offers no guarantees, and sometimes, it may not be possible to pull your money out…even at a loss. Understanding this point is very important to appreciate the next point.
If investors were offered returns that were slightly lower compared to typical stock market returns, but totally safe, would it interest investors? Quite often, the answer is yes, especially if investors think stocks will decline in the near term. So, when bond yields increase, many investors flock to buy bonds (which leaves fewer buyers of stocks in the market). Some may even sell stocks to release cash to buy the bonds (which of course causes price of stocks to decline).
Indeed, as Powell spoke, the yield on the 10-year Treasuries inched up, hitting 1.54%, a big move from the end of last year when it was trading below 1%.
Inflation and Interest rates
Adding to market jitters about the global economy was Andy Haldane from the Bank of England. He said borrowing costs may need to go up sooner than the City expected to tame the inflationary threat.
Looking at inflation requires a look at interest rates, too. Inflation can be thought of as the annual rise in the price of products and services. This can be caused by many factors, but ultimately, it boils down to supply and demand. Rapid inflation is bad news for everyone. Just ask any Zimbabwean.
Inflation and interest rates is a sort of balancing act. Too much inflation is, of course, bad. It pushes up the cost of living.
So when does inflation occur? It occurs when the supply and demand see-saw is imbalanced. If there is too much demand, it means the price of things go up. Low borrowing costs (linked to low interest rates), helps to create ‘demand’. One way for governments to curb inflation is to raise interest rates (which dampens demand). When this happens, borrowing money becomes more expensive.
When central banks increase the cost of borrowing, it has a knock-on effect. Non-central banks, who borrow from central banks and lend out that same money to consumers, pass on the higher costs to consumers. In theory, someone on a variable rate mortgage will have to pay more for their mortgage, leaving them with less disposable income. Spending less in the economy is bad for businesses. And of course, many of the companies listed on stock exchanges around the world are consumer facing ones. To be clear, in the context of the stock market, a rising interest rate is bad news because:
It becomes more expensive for companies to borrow money. This may affect a company’s growth if it decides to postpone expansion, and if it owes the bank any money, it will probably cost more to service the loan repayments.
Mortgage and other living costs may increase for consumers. This means consumers may have less disposable income. Since many publicly traded companies are consumer facing ones, this usually means lower earnings (particularly for non-essential businesses).
In fact, some experts say rising interest rates represent the single biggest threat to the bull market right now. Further, many analysts say inflation nearing 3% would begin to spell danger for stocks, and anything from 4% to 5% would prove an absolute disaster.
History demonstrates that a high and volatile inflation regime is associated with very low price/earnings multiples,' says Chris Brightman, chief investment officer at Research Affiliates. 'High inflation is an unambiguous negative for stock prices.' Fast-rising prices would force the Fed to throttle the economic engine by raising rates, a move that would hammer corporate profits."
On the one hand, higher interest rates makes borrowing money more expensive for companies. But that same interest-rate increase leads to higher yields for government bonds. An exodus of investors’ money from the stock market leads to stocks falling since investors sell up and put their money elsewhere.
In addition to high bank loan costs, very large organisations may issue bonds to raise money- just like governments do. If any government raises the yield for bonds, so too must large corporations in order to compete for investors’ money.
This is all, of course, macroeconomics, which takes months to take effect. Investors, however, react quickly to such news. Remember, investors need to deploy and re-deploy their money efficiently all the time. A decrease in earnings from the stock market may mean investors choose to exit a stock by selling it and then redeploying that same money elsewhere. This causes stock prices to go down (because too many people selling stock equates to a lack of demand, and low demand causes prices of things to fall).
Understanding the different cogs in the economic engine helps to understand how one cog causes another to rotate. So, next time you think there might be a rise in interest rates, you’ll be better equipped to make a decision on what to do with your stocks.
If you feel there’s a lot more to learn, consider joining my free 30 Day Trading Programme. In it, you’ll learn about Islamic Principles of Investing, Basics of the Stock Market and Trading Online (using a trading platform).
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