Monday, September 7, 2009

What Might Interest Rates Be Telling Us?

It's no secret that historically, the stock market and interest rates have been highly correlated. This correlation factor is critical when we are striving to protect ourselves through the creation of a diversified portfolio. When stocks go up, interest rates should also be going up (bond rates and bond prices move inversely) as both indicate a strengthening economy and a greater demand for money. As early as 2005, long before the market meltdown, I observed that there was something very wrong with both the stock and bond markets rallying sharply Stock Market Disconnect. I often wrote about this calling it The Tale of Two Markets. It was the best of economies (with stocks making new highs) and it was the worst of times (with interest rates making new lows). How could the markets accomodate two totally opposite theories? In my view, the global bond market information should always win out as this marketplace is so huge.


That this correlation was important turned out to be an understatement as stock prices came down, and in a hurry, to meet the interest rate line that it had previously been tracking. As it has been said millions of times,"the market can remain irrational much longer than I can remain solvent" really holds true here. Look at how long stocks continued to move well ahead of interest rates! I had been calling for 6,500 on the Dow as early as 2005. Many others were also right but as stocks continued to rise, the voices of reality begin to go unheard. In the end though, stocks and interest rates came into alignment.


With this relationship being so strong, it's important that we keep track of it from time to time to see exactly where we are. Again, we see these two markets diverging. And while this divergence is not as great as it has been in the past, it is important that you are aware of this information. Stock prices continue to rise even though interest rates are falling. If the economy were really strong, 10-year interest rates would be well above 4%. They tried to break through this level a few months ago but quickly retreated. Some are expecting the 10-year rates to trade as low as 3% in the near future. Can the stock market continue to soar when interest rates imply that the economy is weak?


It's true, what can you gather from any market information that we see? When you try to make real sense out of things, there is none. This is the problem you have when the government and Federal Reserve intervene in the marketplace and try to massage the business cycles to their liking. The Federal Reserve is adding trillions of dollars to the economy forcing asset prices to rise (even though they say that there is no inflation!!!!). At the same time, the Federal Reserve is also supporting treasury securities as well as mortgage-backed securities pushing interest rates down. And while some of the business statistics appear to be improving, can you really be sure? Do you really understand what all of the numbers mean and how these numbers are calculated? Or do you rely on government-owned mouthpieces such as General Electric's CNBC tv station? While I am not accusing anyone of anything, I'm just pointing out how nicely controlled everything is. The government pumps in the money to make prices go higher (causing you to be excited about things). The Federal Reserve pushes down interest rates (enticing you to buy more things that you can't afford) and the stock market media (subsidized by the government) is telling you how we are in a new bull market and the world is saved (even though there are some 500,000 + initial unemployment claims each week).

How do you spell M-A-N-I-P-U-L-A-T-E-D


This, of course, is the million dollar question. (A lot more for those who trusted Bernie Madoff and others like him). It is why I strongly advocate that everyone has a comprehensive financial plan. The comprehensive financial plan enables you to take a good look at where you are today and where you want to be in the future. You can see what your annual required rate of return is to achieve your goals. Once you know this, it's so important that you set aside your goal funding and do all that you can to achieve this required rate of return with the least amount of volatility. It is very possible to make an annual return of 8% to 10% each year despite what the markets do. If this is what you need to achieve your goal, then you should manage your portfolio in such a way to achieve this goal with the least amount of risk. This is not to say that you can't have fun in the market. You can have extra money set aside for fun. But you should not be putting your future livelihood at risk if you don't have to.

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