This note on the stock markets was sent out to Personalfn's clients on the 18th of May 2006. We have reproduced the same here for the benefit of all our visitors.

Among the key probable reasons the stock markets are falling are -

• Recent inflation data and comments by the Federal Reserve Governor which led the markets to conclude that interest rates in the US may rise still further. The benchmark Federal Funds Rate has already gone up from 1% to 5% in the last two years or so. Most market watchers did not see it rising any further this year; but now it seems almost certain that interest rates will move up still further. The impact of higher interest rates has been discussed later in this note.
   

• Although globally stock market valuations have been on the rise in recent years the Indian markets have witnessed an even sharper rise. We are at present among the most expensive emerging markets in the world. A correction will tend to impact us more than our relatively more inexpensive peers.
   

• All asset markets, including real estate, commodities and stocks have witnessed a fantastic bull run in recent years. A majority of investors carried irrational expectations that nothing could go wrong (remember the confident talk of Sensex at 15,000). And as always happens, this is just when something goes wrong (hubris). The sell off in commodities quickly spread to the futures and stock markets. And before one could take notice, we had lost 1,300 points on the Sensex.

What should you do now?

• Do not panic; remain disciplined and stay committed to your investment plans. As we have often mentioned, the markets will do these kinds of things once in a while; but it will pass. In the long run, a disciplined investor will see his objectives being met.
   

• In our view, the long term investment opportunity presented by the Indian stock markets remains unchanged. The fundamentals of the economy and the companies continue to be generally robust; we expect a 15% sustainable growth in earnings over the next few years. This should over a period of time translate into a 15% return from the stock markets
   

• If you have the risk appetite, consider investing some of your surplus (15  20%, depending on your overall asset allocation) to the existing mutual fund schemes that you own. We believe that a well managed diversified equity fund will be able to generate a return of about 15% CAGR over a three to five year period. Such falls in the markets are more of an opportunity than a threat.

How do rising interest rates impact companies/stock markets?

1. Consumption funded by debt (cars, durables included) will get impacted; investment activity too will get hit as funding costs increase even as general demand levels weaken. This will impact present and future earnings of companies.
    

2. As consumption demand weakens, the demand for commodities like copper and aluminium will slow down. This will impact prices of these commodities and therefore profitability of companies that deal in them (notice the fall in the stock prices of commodity stocks).
    

3. Hedge funds and investors who borrow and invest in the markets will undoubtedly demand a higher return from the stock markets (for the initiated, in a discounted cash flow analysis, if the expected return is increased, the current value of the stock will need to adjust lower to be able to yield the expected return); this in turn means lower current stock prices. The rising cost of money could also lead such investors to unwind their stock holdings.
    

4. Finally, rising interest rates make investment in debt instruments relatively more attractive as compared to other asset classes. At the margin, therefore, money could move to the debt markets instead of the stock markets. This could hit sentiment that is based on large fund flows into the stock markets.

Add Comments