If You're Worried About Rising Interest Rates, You Need to Read This... - The 5 Minute WrapUp by Equitymaster
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If You're Worried About Rising Interest Rates, You Need to Read This...

Jun 13, 2018

Sarvajeet Bodas, Research analyst

1 December 2014 is an important date for long-term investors.

That was the last time the interest rate on the 10-year Indian government bond closed above 8%.

Fast forward to 9 June 2018.

And the bond yield briefly breached 8% again.

That's a gap of more than three and half years.

In those three and half years, crude oil has completed the full price-cycle... first high, then low, and then high again.

But today, I'm writing to you about the more important cycle - the interest rate cycle.

Higher Interest Rates Ahead?


Last week, the RBI increased the repo rate after a gap of more than four years. Inflation was rising. Thus, a tighter monetary policy was around the corner.

With this move, vis-à-vis the risk-free interest rate on the benchmark 10-year government bond crossed 8% on Friday morning.

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You see, vis-à-vis the risk-free interest rate is important. It reflects the collective wisdom of investors on the likely direction of the economy and inflation. We research analysts use it as a guide to value our stock recommendations.

And there's a good reason for this...

It's based on the principle of the time value of money.

Here's a simple example.

With an annual interest rate of 6%, you would equally accept Rs 100 today or Rs 106 next year. It would be the same.

Now, if the interest rate rose to 8%, for Rs 100 today, you would demand Rs 108 next year to compensate for the rise in the rate.

The same thing happens with stocks.

Higher interest rates mean investors take a dimmer view of a company's future profits.

How?

Investors price a company's stock as the value of all its future cash flows discounted back to the present.

So, if interest rates go up, those future cash flows are worth much less today.

And if investors anticipate rapidly rising rates, they'll push down stock prices.

But sometimes, it gets interesting.

If investors' expectations change suddenly, and fear sets in, then stocks can plunge, even in the middle of a longer-term bull market.

Should this worry you?

No.

There is bigger factor at play - the quality of the company behind the stock.

Companies that are well-managed.

Companies that are steadily growing their profits.

Companies that have seen several business cycles and emerged stronger every time.

Companies that are safe and have proven track record.

These are the companies you need to back with your money.

This is how India's best investors pick stocks. They don't worry about rising rates and instead focus on owning good quality companies.

And when the market dips, just like these superinvestors, you too should buy more of these stocks.

Don't worry about rising interest rates. Buy the best stocks while they're on sale and you will set yourself up for huge gains for years to come.

Chart of the Day

The earnings yield of the market vis-a-vis risk-free 10-year government bond yield is a very important indicator for equity markets.

The earnings yield is calculated as the net profit for the last 12-month period, divided by market capitalisation. In other words, it is the inverse of the PE Ratio.

This ratio can be used as a tool to identify how cheap or expensive the stock market is relative to the debt market, other any other possible investments.

Today's chart illustrates the same.

The Gap Widens Between Bonds and Stocks

Lately, the divergence between bond yields and earnings yield has increased. This means stocks have become expensive compared to bonds.

Historically, there is a negative correlation between stock prices and the spread of bond yields over earnings yields.

The bond yields are now higher by 364 basis points (bps), compared to the average earnings yield of the BSE Sensex.

With this, the equity market might see more selling in the coming weeks, as there is still a large gap between the yield on the 10-year government bond and corporate earnings yield.

Thus, a 30% correction in the Sensex is a possibility.

Regards,

Sarvajeet Bodas
Sarvajeet Bodas
Research Analyst, Smart Money Secrets

PS: For over 16 years, members of the exclusive Bombay Investing Society have received safe stock recommendations that generated double, even triple digit returns! This society is currently accepting new members. Click here to find out how you can join...

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2 Responses to "If You're Worried About Rising Interest Rates, You Need to Read This..."

Padam Singh

Jun 13, 2018

Showing analysis of old, what about current couldn't say

Like 

Gopalan N

Jun 13, 2018

Dear Shri Bodas
Very nice article. Quoting from artice above,
QUOTE: "The bond yields are now higher by 364 basis points (bps), compared to the average earnings yield of the BSE Sensex.
With this, the equity market might see more selling in the coming weeks, as there is still a large gap between the yield on the 10-year government bond and corporate earnings yield.
Thus, a 30% correction in the Sensex is a possibility." UNQUOTE

The current surge in the market is through unprecedented mutual funds, maybe SIPs etc as there do not seem other avenues to invest. Under the circumstances as the flow is unstoppable, will markets try to come down?

Best Regards
Gopalan

Like (1)
  
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