WASHINGTON, Nov. 7, 2015 – While stocks were weakly up on Friday, at least in the Dow Jones Industrial Average (DJI or DJIA) and the NASDAQ, the more wobbly and broader-based S&P 500 index was off fractionally, providing a truer picture of Friday’s trading trends.
Mush-mouthed pronouncements from Fed chair Janet Yellen and other habitually yappy Fed governors created a fairly distinct impression that it was “Damn the torpedoes, full speed ahead” for the Fed with regard to increasing interest rates sooner rather than later, i.e., in December rather than somewhere far off in a galaxy far, far away.
Traders and likely HFTs took this as a negative and were slowly and steadily dumping stocks this week, an activity masked by very low volume and by the market’s generally bullish tone. Most of this bigwig selling action had actually been accomplished earlier in this helter-skelter trading year, so current selling is basically late season cleanup. The damage has already been done and will take quite some time to repair, particularly in a dubious investing climate where no one really has a clue any more as to what’s going on with business, government or anything else.
The result of the general ongoing confusion, plus the perception that the Fed really means it this time with regard to that slight interest rate rise, gave traders a mixed bag of results this week with the trend essentially up, but internal sector rotation taking place to confuse things.
A short primer on bonds and interest rates
The “scary” Fed interest rate news, as one would expect, hit bond prices this week. The general rule of bonds is this: When interest rates are going up, bond prices are going down. When interest rates are going down, bond prices are going up.
The reason is quite simple. In general, when a bond starts out its existence, it’s priced at par, generally understood to be a principal amount of $1,000 per bond purchased. Its original interest rate, or more quaintly, its “coupon” is fixed based on that opening principal amount. In other words, if I buy a new bond today for $1,000 and it’s offering a 5 percent interest rate, I’ll be paid $50 in interest per year for as long as I hold that bond, or $25 semi-annually, which is generally how often a bond pays interest per year.
But once my hypothetical new bond opens for trading, its price will fluctuate up or down from its original principal amount depending on where market interest rates end up on any given day. If a new bond that’s issued tomorrow comes at, say, 5.5 percent, the value of my bond will decline a bit from its principal amount to reflect the fact that if I sold my bond to someone else, he’d also be expecting to earn the same rate that a purchaser of this new bond would get.
Likewise, if interest rates on a new issue bond go down tomorrow, say to 4.5 percent, then my bond might actually increase in price, exceeding par value ($1,000) since a buyer of my bond would have to pony up extra for that better interest rate.
Bonds priced over par are regarded as premium-priced, whereas bonds priced below par are “discounted.”
What this boils down to is that on the day a bond is priced and the day that it is redeemed at the end of its stated term—5, 10, 20 or 30 years—my bond is at par value, $1,000. But all the time between, its price, were I to sell it, would fluctuate up or down depending on where interest rates are going at any given time.
There’s a reason why we paused to have this little discussion.
Why REITs, utilities, consumer staples get hit when the Fed raises rates
Real estate investment trusts (REITS), utility stocks, high dividend paying stocks and consumer staple stocks that pay high dividends all tend to get hit just like bonds when interest rates start rising or are believed about to rise. Given their generally high and often stable dividends, these stocks are often the investments of choice for those seeking income over capital gains, such as folks who are already retired and on fixed incomes.
Problem is, when interest rates go up, these stocks tend to behave just like bonds due to their generally high yields. So, no matter how well any of these companies and stocks happen to be doing, business-wise, they’ll get hit and hit hard when interest rates threaten to go up.
That’s why these sectors were among the worst performers this week. They’re bond proxies, and as such, those investing in them didn’t like what they were hearing from the Fed, so many started selling these sectors.
Why banks, brokerage firms and insurance companies love it when the Fed raises rates
In the case of these stocks, an environment where interest rates are on the increase is to a great extent very good news, particularly now, roughly eight years after real interest rates (except for you and me, of course) went down the rabbit hole to near zero and stayed there.
Why good news? Again, quite simple. Traditionally, banks make a great deal of money loaning money out and collecting interest on the outstanding balance over time. The higher the rate they can loan out this money, the greater their return and thus, the greater their profit essentially for doing the same work.
Insurance companies work in a similar fashion, except for one thing—they often buy bonds, real estate and other generally stable investments to get the returns, enabling them to more easily earn money to pay out claims, earn profits for themselves, and do the things they do.
Ditto brokerage houses, which not only make money on commissions but also on money loaned out at profitable rates via margin accounts.
During the past eight years or so, however, all these institutions have struggled with close to a zero-interest rate environment, hampering their ability to earn normal and customary returns. If interest rates start going up, they’ll start earning more money.
Upside? Swell and bigger profits as interest rates start creeping back up. Downside? Loans will cost us more. Upside? At least maybe some of us will actually be able to get a loan, given that lending institutions in this environment are more interested in loaning money to rich guys like Warren Buffett rather than little guys like you and me. It’s all a mixed bag.
But the bottom line here is that increasing interest rates mean that just maybe happy days are almost hear again for stocks in the financial sector, which is why many of them got a tremendous boost on Thursday and Friday after the Fed’s muddle of a message was sorted out.
That’s the story of the markets this week, pure and simple. There are more nuances than we’ve discussed here, of course. But that’s the heart of the message. And it’s why investors and firms were jumping out of certain stock sectors and into others.
The trend, as usual, is your friend, and all this is likely to be the trend again in the coming week’s trading action. Unless, of course, the Fed plays another Lucy, as it did in September, by pulling that interest rate football away from Charlie Brown once again.