As a Stock investor, it’s important to be aware of the relationship between the economy, interest rates, and Stockmarket performance. This will allow you to make better, more informed decisions about where to invest, anticipate market corrections, and protect your investments.
Interest Rates and the Economy
The starting point is understanding the economy and how it is performing. That's because the strength of the economy is the main driver of the level of interest rates. Market professionals watch interest rates closely as they impact the performance of all major asset classes (Stocks, Bonds, FX, Commodities, Real Estate).
If you're a serious investor looking to make money, you need to do the same.
Develop the habit of monitoring key economic news announcements, in particular those from Central Banks such as the FOMC. That's because you will increase your trading edge. Furthermore, you will be able to allocate your wealth more wisely and anticipate future market sell-offs.
Here's what you need to do next.
First of all, you need to plan ahead. Do so by compiling your own investment calendar of upcoming news announcements. Prepare this at the start of each month and set a reminder for each announcement in your google calendar.
A good free source of news announcements can be found on Marketwatch .
The key news announcements that I track are;
1. Economic Growth
GDP releases - are the official government measure of economic growth
Unemployment figures - the lower the number, the stronger the economy
ISM index readings - 50 is a key level between expansion and contraction. A with above 50 is a sign of a growing economy
Non-Farm Payroll data releases
2. Inflation releases
CPI and PPI data show the impact of inflation on food prices and commodities such as oil
3. Interest Rate Announcements
FOMC or equivalent Central Bank Announcements
4. Company Earnings Announcements
These often lead to increased volatility in the Stockmarket
When do Stocks do well?
"Stocks perform well when the economy is growing and there is low inflation"
This is because;
Economic Growth feeds company earnings and ultimately higher profits
Low inflation allows interest rates to be kept low. These benefit households who have more money to spend on big-ticket items such as new homes and cars, or lifestyle expenses such as clothing and vacations. This spending will result in increased company earnings and ultimately higher stock prices.
Low-interest rates make stocks more attractive to own compared to holding cash. Consequently, this will drive stock prices higher.
Why Rising Interest Rates Hurt Stocks
Have you ever wondered why the Stockmarket can be so volatile at times and never understand why? It's a good question. This is due to an interesting dilemma impacting the Stockmarket.
Let me explain.
"The Stockmarket likes company profits but doesn’t like rising interest rates."
The Stockmarket likes profits because they help companies pay higher dividends. That’s why the Market eagerly awaits earnings season for companies to announce their latest profit results.
In contrast, the Stockmarket does not like higher interest rates. That's because they lead to higher borrowing costs which reduce company earnings and lower profits. Consequently, shareholders receive lower dividends. This also makes Stocks appear less attractive compared to the returns available from holding Cash, Real Estate, or Fixed Income investments.
Higher interest rates also mean analysts and investors deploy an increased discount rate in their models used to calculate the Net Present Value (NPV) of future cash flows from long-term growth stocks. A higher discount rate means a lower NPV. And that results in a lower value for the stock and its share price.
Here’s the dilemma
Profits and interest rates tend to rise and fall together, in line with the performance of the economy. Consequently, Stockmarkets are receiving both good and bad news at the same time.
As a result, the prospect of higher interest rates will usually have a bigger impact on the market than company profits. This also explains why stocks sell off so heavily in anticipation of rate rises.
What Does the Future Hold?
It all comes down to inflation which investors should watch closely. Inflation is what Central Banks globally are trying to control by raising interest rates. Over the course of 2021, US Inflation jumped from 1.4% to 7%, the highest level in almost four decades. Over the next few months, we are likely to see inflation data remain high, before pulling back towards the end of 2022.
So why does it matter?
Elevated inflation has the potential to put the brakes on the economy. Consumers spending powers will be curtailed by inflation outstripping wages growth with incomes starting to fall in real terms. So they become more cautious and spend less, particularly if they have an adjustable-rate mortgage. And inflation is bad news for Corporate Margins and ultimately lowers Earnings expectations too.
What to Expect
It's fair to assume that interest rates will be higher in 12 months than they are now. As I update this in early February 2022, the market has priced in 3-4 Fed Fund rate increases in 2022, which is data-dependent. So a pullback in inflation later in 2022 could see fewer increases. So expect more market volatility in 2022.
“This will lead to higher market volatility, which increases the probability of future market sell-offs.”
And Warren Buffett shares a similar view.
"Anything can happen to stock prices tomorrow. Occasionally there will be major drops in the market, perhaps 50% or more" Warren Buffett
Does that mean you should stay out of the Stock Market?
If the low growth, low inflation, low rates of the past decade are replaced with higher inflation, higher growth, and higher rates, it would be logical to expect that the outperformers from the last decade (bonds and tech stocks) to struggle with a rotation into the underperformers (value stocks, commodities, energy, and financials).
In conclusion, you should remain vigilant and be prepared for further market turbulence ahead.
Hedge Against Market Volatility
Smart investors are wise to stay ahead of the game by hedging their stocks against further price falls using Put Options.
And you can do the same. All it takes is more knowledge and your action. Learning how to use options will help you reduce your potential losses and navigate the inevitable choppy waters more safely. That way you can spend less time worrying about your investments and more time doing the things that you enjoy.
If you would like to learn more about Put Options and how you can use them to protect your stocks, I want to show you how.
Here's What to Do Next
I’ve created some free stockmarket training for you and I’d like you to have it.
This will allow you to learn more about investing in the Stockmarket and our online Learn to Trade Programme. This is designed for people who want to take charge of their finances, invest for the long-term, earn more, and become financially secure.
Here’s what you will learn in this training:
How to reduce risk and invest in Stocks in a safe and steady way
How using options will allow you to create an additional monthly income and boost your returns in only a few hours per month
How you can protect yourself from the Next Stock Market Crash, so you can worry less and focus on the things you enjoy