We mentioned it yesterday.
What if interest rates go up?
Does that mean stock prices will fall?
Well, there’s evidence to say stocks may not fall. But that doesn’t mean they won’t.
So to be on the safe side, you need to take precautions…
Free Reports:
Yesterday we showed you a chart of US interest rates rising in 2004.
The US Federal Reserve began raising interest rates when it figured the recession had ended.
During 2003 the US stock market had also gained 35%.
The Fed figured it was time to act before things got out of control. Before the low interest rates could cause another bubble.
In the short term it worked; the stock market spent most of 2004 going sideways.
But it didn’t last long. Rising interest rates did nothing to stop stock prices from climbing.
You can see the sideways trend of the US S&P 500 index in the chart below.
Just like today’s market, you can see a lot of volatility, but it’s a market that’s really going nowhere:
That was until investors began to believe that stocks could go up even while interest rates went up.
That’s the set-up facing investors today. They’re convinced interest rates are on the rise. They know that should be bad for stocks. But they’re not sure. So they don’t want to completely sell all their stocks.
So, they’re holding on…buying on the dips and selling on the peaks.
If the market repeats what it did 10 years ago, then buying on the dips and not selling on the peaks could be a sound idea.
From the end of 2004 to the peak in 2007, the US market gained another 32%. Investors who missed out on those gains would have kicked themselves.
The Australian stock market did even better, gaining 51%. That was of course largely thanks to the mega-resources boom and China’s rapid growth.
But what if the same story doesn’t play out today? Then what should you do?
Well, those who missed out on the boom from 2003 and 2004 can satisfy themselves in the fact that when stocks crashed in 2008, the indices fell to below the 2003 level.
They can say that they could have bought back in during late 2008 and 2009 and not have missed out on the gains.
That makes sense…on the surface. However, there are two problems with that argument.
First, this argument tends to ignore one important factor — dividends. The following table shows you (in rough terms) the value of a $10,000 share portfolio in 2003 that paid a 5% dividend and didn’t increase dividends over the past 11 years.
In other words, even taking into account the 2008 mega-crash, stocks have still returned 172% over the past 11 years. That’s an average of 15% per year.
These are conservative numbers too. It doesn’t take into account growing dividends. And it doesn’t take into account reinvested dividends. Plus, it doesn’t take into account further contributions to a share portfolio in the intervening years.
But there’s another reason those who missed out shouldn’t feel too smug. Because as much as they’ll say the boom was a waste of time because the market fell again, and that they could have bought again in 2009, the reality is that they didn’t buy in 2009.
When the crash came, instead of seeing it as the opportunity of a lifetime to load up on stocks, they got greedy. Instead of seeing the 50% drop as an opportunity, they went all in and said the market would need to drop further before they would buy.
The result? They missed out. Today, their $10,000 cash investment — even with compounding interest — is only worth $17,103. That’s assuming a generous 5% average annual interest rate.
Look, we’re not convinced that interest rates will go up.
But if they do, it doesn’t necessarily mean that stocks will fall. The market action during 2004 and after is proof of that.
So what’s the solution if rates rise and stocks fall?
Ironically, one solution is to use a method that we’ve long championed. That is to use the power of compounding by reinvesting dividends. We know that’s counter-intuitive.
But by reinvesting dividends, you’re increasing your exposure to the stock market, but you’re also compounding your returns. That means you’re able to boost your returns during stock market rallies.
Sure, it means that, in dollar terms, the value of your portfolio will fall more if or when the market falls, but when it takes off again you’ll start from a higher base than if you didn’t reinvest dividends.
Meanwhile, as long as the company keeps paying dividends, the compounding effect keeps working, even during a falling or sideways market.
So, the upshot of all this is the same as always: the investors who lose out most during volatile and falling markets are those who panic. Those who have a plan in place (remember the idea of ‘safe money’ and ‘punting money’) should always fare better.
Providing you don’t panic, and don’t invest more in a single stock than you can afford to lose, volatile markets should be an opportunity, not a threat.
Bottom line: we’re using this market to increase our exposure to stocks. And if you’re as confident about rising stocks as we are, this should be the time to buy rather than sell.
Cheers,
Kris+
The post What Happens if Interest Rates Go Up? appeared first on Stock Market News, Finance and Investments | Money Morning Australia.
