The stock picker
Monday, October 26, 2009
One of the main factors in stock market performance is determined by interest rates, or so it has been observed.
The dependency of our economy on interest rates is based on the fact that everything we do requires money. To create value out of nothing, we treat the concept of money as something tangible and assign a cost to borrowing capital, a cost that we call interest.
Empirical data (read any economics and finance book) show that as interest rates increase, which makes money more expensive, the equity market suffers. The opposite is true as well: as interest rates decrease, the stock market begins to perform better and to yield better returns.
The theory states that as interest rates increase, investors take money out of the stock market and begin investing in more secure investment vehicles, for example, in bonds, T-bills, or other capital investment that assure the protection of capital.
Again, as the rate of return on any investment increases so does the risk. The stock market has been known to outperform secure-capital investments, though the risk is greater. Leaving all the math of theoretical models aside, as interest rates increase, the rate of return of secure-capital investments increases. And as for any rational investor, less risk for the same return is better. Therefore, the equity market suffers because investing in companies futures is riskier and money starts flowing out of the stock market into bonds, T-bills, and other fixed income commodities.
At the end of the day, however, the market is not a rational entity: investors are driven by emotions, resulting in bubbles, crashes, and inside trading fiascoes. Nevertheless, the manipulation of interest rates has become the main tool for governments to maintain order in world markets. For instance, Obama's policies seem to be working. The idea is to keep us going: as long as we keep buying and consuming goods, we will continue to maintain and to create jobs that support the cycle.