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Interest Rates and our Stock Market Investments

A few weeks ago, I wrote an article pertaining to The Yield Curve which describes a graph of the interest rates of short, intermediate and long term treasury debt securities. This sparked dozens of questions and comments from our readers on this subject so I thought I’d follow-up with some basic economic information on the impact that interest rates changes have on the stock market. The importance of this subject is made crystal clear as we listen to sophisticated market investors and commentators follow every move and guidance statement made by the Fed.

The mission of the Federal Reserve is to promote economic growth and control inflation. One of the most powerful tools used in this regard is the U.S. Federal Reserve’s federal funds rate. This is the cost that banks are charged for borrowing money from the Federal reserve banks. It is the main way the Fed attempts to control inflation. By raising the federal funds rate, the Fed attaempts to lower the supply of money because it becomes more expensive to obtain.

When the Fed increases interest rates:

Consumers are now paying more for credit cards and mortgage interest rates thereby decreasing the discretionary money they have to spend. This has a negative impact on a business’ income and profit. Businesses themselves are effected as well, in that they tend to borrow less because the cost is more expensive. This slows down economic growth resulting in lower corporate profit.

Another negative impact higher rates have on companies and the stock market is related to the Discounted Cash Flow (DCF) method of evaluating equities. Analysts detrmine the value of a stock by projecting its future free cash flows and then discounts those figures back to the present. If a company is seen as cutting back on its growth spending, the price of the equity will decline.

When we invest in the stock market, we are incurring additional risk over treasury debt investment risk (actually considerd risk-free). We do so because we anticipate a risk premium over and above the risk-free rate of return of (let’s say) treasury bills. As the risk premium decreases, investors may decide to move their capital into substitutes. Rising short-term interest rates tend to push up longer term bond yields making these less-risky investments more attractive and put additional pressure on stock prices.

Conclusion:

When the Fed raises rates that it lends to banks, it will have a negative impact on consumers, businesses and the stock market as it attempts to control inflation. As we approach a rate cut cycle (one we are in the midst of right now), the opposite normally holds true. Take a look at the chart of the S&P 500 since March as the interest rate cuts have taken hold:

S&P 500 as of 9-09

S&P 500 as of 9-09

 

According to S&P Equity Research, the S&P 500 returns 8.2% per year. Twelve months after a rate hike, the average declines to 6.2% while twelve months after a rate cut, the average increases to 15.5%. This folks is why we watch the Fed and the moves and comments it makes in regards to interest rates. For current data on the fed funds target rate use the following free link:

http://www.newyorkfed.org/markets/omo/dmm/fedfundsdata.cfm

 

Last Week’s Economic News:

This weeks economic reports still seems to support the case for the start of economic expansion. The manufacturing-sector and service-sector activity as measured by the Institute for Supply management (ISM) both rose in August. Although the unemployment rate rose to to 9.7%, the highest level since 1983, the loss of jobs is slowing. Minutes from the mid-August Fed meeting note that the nations central bank anticipates that the recession will end before the end of the year. It also stated that “inflation will remain subdued for some time”. For the week, the S&P 500 dropped 1.2% for a year-to-date return of 14.5%

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 I hope you’re all having a happy and healthy holiday weekend.

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

16 Responses to “Interest Rates and our Stock Market Investments”

  1. Brian September 7, 2009 4:05 am #

    Most of the stocks on this weeks IBD that passed the screens were already on my watchlist. I did add cam, hmin and med.

    Brian

  2. Wendy Grimm September 7, 2009 11:08 am #

    Hi Alan:

    I have read both of your excellent books. I was wondering whether you made money in 2007 and 2008 using your system?

    Thanks.
    Wendy

  3. admin September 7, 2009 11:24 am #

    Wendy,

    In 2007, when the S&P 500 was up 5%, my covered call accounts were up 33%. In 2008, my accounts were down 15% when I went into cash seven months into the year. This year, I’m back into the market and earning 2-3% per month selling predominently I-T-M strikes.

    Alan

  4. Wendy Grimm September 7, 2009 3:53 pm #

    Alan:

    Due to the fact that we seem to be in one big bear market rally and chances are good that the market will make a quick downturn at some point, shouldn’t preservation of equity be the main concern? In other words, if someone has a fairly tight mental stop loss on equities, at the point that the stop loss is hit, the options may not be ready for sale in accordance with your 20% and 10% rules for selling. However, in this environment chances are good that when there is a sell-off it will be a doozy and I’m not sure it is wise to wait around until the options are properly priced to buy them back. I guess in that scenario even the fact that SOME money will be made when the calls are bought back will offset the loss. What is your feeling on all of this?

    Thanks- Wendy

  5. admin September 8, 2009 10:48 am #

    Wendy,

    Your comments are much appreciated as it highlights two important facts regarding investing in general.

    First, the fact that you feel that there is a good chance of a doozy of a sell off highlights the dichotomy of opinions relating to the future direction of the market. Many experts agree with you and just as many think otherwise. Although the economic news of late has been mainly positive, there is concern for a correction of the recent gains in the market. Many technicians look at the three distinct bottoms that normally show before coming out of a recession. Who is right is yet to be determined.

    The second interesting point is that despite your conviction, you are still willing to stay invested in equities. This highlights the fact that investors have different levels of risk tolerance. Some might flee into cash if they felt strongly about the possibility of a downturn. Others (like us), invest cautiously.

    The 20%/10% rule as set forth in “Exit Strategies for Covered call Writing” is a guideline that has worked extremely well for me in most market conditions. Remember, however, that as free-thinking Blue Collar Investors, we have the flexibility to veer from these rules. See #4 on page 20 of this book.

    For those new to this site, I have been fully invested in the stock portion of my portfolio for most of this year, selling I-T-M strikes, thereby garnering additional downside protection. This approach has been working well for me.

    To a great extent how you handle your investments will depend to a large degree on your outlook of the market trend and your risk tolerance.

    Alan

  6. Chris September 8, 2009 10:58 am #

    Alan,

    IBD 100 question

    The online IBD 100 list can be sorted by “smart select” so you can get to the stocks BCI system is looking for quickly. You can pick a stock, say 10 down from the top, and see if everything is green. Move up or down to get the cut off.

    However, I am not seeing anything to note whether they are optionable. Do you know of anything quicker other then looking at the printed version and cross referencing? You also can download this sort to an excel file and see more data and you know where the cut off is.

    THX!!

    Chris

  7. admin September 8, 2009 11:06 am #

    Chris,

    Thanks for this great suggestion.

    To get information on which stocks have options from the IBD site:

    OPTIONABLE STOCKS located from IBD WESBITE

    1- Go to the IBD Homepage

    2- Click on “Stock Research”

    3- Go to Options Center

    4- Scroll down to “Stock Lists”

    5- Click on “All options sorted by symbol”

    Here is the direct link:

    http://www.investors.com/StockResearch/OptionsCenter/reports/allstocks.aspx?reportType=2

    Alan

  8. Gary September 8, 2009 4:48 pm #

    Alan,
    Just following your response to Wendy question.
    What percentage of your portfolio you are keeping in stocks and what is the rest portion?
    Thanks
    Gary

  9. admin September 8, 2009 5:30 pm #

    Gary,

    My portfolio consists of (from highest percentage to lowest):

    Real Estate

    Business ownership

    Stock (covered calls)

    Bonds (I-Bonds)

    Cash

    The appropriate mix is dependent on your specific needs, risk tolerance, time frame and other factors.

    Alan

  10. Don, September 9, 2009 6:45 am #

    Hi Alan,

    I bought CTSH after seeing one of your recent videos. I paid $35.24 and sold the September 35 call option. The stock is now trading at around $37. Is it too early for an exit strategy? In your book you say “on or near” expiration Friday but I’m not sure if the week before is okay.

    Thank you.

    Don

  11. admin September 9, 2009 3:54 pm #

    Don,

    I am in the same situation. CTSH may very well be a candidate for a rolling out ( or and up) but it is a bit early to take action. As the time decay of the September premium erodes over the next 7 days, the corresponding October premium will not erode as much. I start looking at expiration
    Friday exit strategies twoard the middle to the end of the last week, usually the last day.

    I look at it that my 1-month 3.5% profit on this deal is now protected by $2.47 of downside protection. Congrats on a great deal!

    Alan

  12. admin September 10, 2009 11:48 am #

    Screen of the Day:

    This IBD list is another great place to locate stocks for our watchlists. Run them through our system screens and see if there are any gems to add to our pool of candidates.

    EQIX and CRM are ranked #2 and #5 on the current list.

    Alan

  13. admin September 11, 2009 6:29 am #

    WXS:

    This company had a positive earnings surprise on July 29th and has raised annual earning projections, estimating a 10% growth rate. The moving average indicators are positive with confirming mixed. At the time of this post, selling the October I-T-M strike will garner a 3 1/2 % 5-week return with a 2.8% downside protection.

    Check to see if this equity has a place on your watchlist.

    Alan

  14. Dave September 12, 2009 8:38 pm #

    Does anyone know if you can write off expenses such as an IBD subscription against the gains from covered call writing? If so, what form would be used?
    Thx, Dave

  15. daveyoscoggins October 17, 2009 7:57 pm #

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    I do hope that one of you has helpful info on this

    Thanks Pal,

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