Making sense of direction and level of Short term interest rates

Strategy: Short term interest rates will tend toward the inflation rate plus the economic growth rate

There is always a great deal of discussion about interest rates, particularly US rates. Short term rates are set by governments and this can be a fascinating process to watch. The rates affect the economy and many of the markets.

The benchmark strategy helps to make sense of discussions about their direction and their level. It is a rough guide which is often missed by many commentators. With this rough valuation target, interest rates are easier to understand than most markets, where it can be hard to have a clue what the prices should be. Equities, the market that most investors concentrate on, do not have this kind of benchmark.

An interest rate is made up of the inflation rate plus a 'real' rate. That is, the real interest rate is what is left after allowing for inflation.

Interest rate
= Inflation + 'Real interest rate'

The economic growth rate is the percentage expansion or contraction in the economy with inflation stripped out. It can be loosely considered as the dividend paid by the economy in general.

Economic Growth rate
= Rate of expansion or contraction in the economy - Inflation

Rate of expansion or contraction in the economy
= Inflation + Economic Growth rate

Over time, the real interest rate moves towards the economic growth rate. In that way, the return from interest rates and the return from the economy in general, are equal.

In 2005, the short term rates in the US are 1%. When they start to rise, how far could they go? In the US in 2005, you may wish to target 4% because inflation was around 2% and growth was also around 2%. Add them and you get the target.

Rates had started moving lower worldwide and the question was, how far they could fall? Using the rate of contraction in the economy and the inflation rate gives you an estimate of the economic growth rate. As over time, the real interest rate moves towards this economic growth rate, using this simple strategy, you can have an idea how much further interest rate could move and in which direction.

As the level of interest rates are somewhat predictable, this benchmark strategy helps you to invest intelligently in the bond market.

Tracking Malaysian Fuel Prices

Be careful at the end of long trends

Another dangerous time in the markets is after the end of a long trend. The fundamentals that caused the trend may have been assessed and fully absorbed by the markets, and, until there are new strong influences, it is hard to have a view.

Choose the right markets

In many cases where you have a view on the economy, or the world in general, there will be different ways to position yourself in the markets.

As an example, if you were bullish about the Chinese economy because of the massive growth potential, some ways to invest would be:

• buy Chinese stocks;
• buy into shipping stocks (prices are already much higher on increased Chinese usage for shipping of imports and exports!);
• buy the yuan (the Chinese currency);
• buy commodities (raw materials), looking for Chinese demand to push up prices;
• buy into a currency that exports commodities (e.g. Australia and Canada); or
• buy stocks in foreign companies who sell products to China, for example mobile phone companies such as Nokia.

There are more. Do your homework to unravel the above example for the right answer. Above all, do not guess.

When you have a way, and there are a number of ways to implement it, look at the following 4 criteria. Choose the market:

1. Where the price has not already adjusted, or has adjusted the least, to the events you expect.

• This could rule out shipping, because shipping prices have already moved substantially higher in line with greater Chinese activity.

2. Where there is the least downside risk if you are wrong?

• If you have more reasons for being bullish on Nokia than just Chinese demand, buying Nokia stock may provide some protection if it turns out that you are wrong about the Chinese.

3. Where there is the least random influences to mess up your idea.

• The announcement of a government election in Australia, for example, would probably dominate the movement of the A$ up or down, and the Chinese economy would have little short term impact. In the event, the Canadian dollar would be better suited as a currency play on China, until after the election.

4. Where you have the best liquidity.

• This is the ability to buy and sell easily and inexpensively. Some Chinese stocks may be too illiquid.

Very often, you cannot meet all the criteria and the different criteria steer you towards different markets. It will then be a matter of judgement.

The challenge is to always think about various opportunities and the risks they involve.

Looking for investing ideas

Where to look for investing and/or trading ideas? There are thousands of different stocks, bonds and commodities. How can an investor find anything?

You need to be inquisitive about the markets. You will probably be drawn to the markets that you find most interesting. As you get to know more, try to identify patterns and anomalies in the way they behave. These will be the basis of your investing and/or trading idea.

It can be rewarding:

1. To be inquisitive, especially in the financial markets
2. To watch crowd behaviour. Jump onto some great trends and jump off when this turn more neutral. Trade with a consensus, rather than against it.
3. To think for yourself. Always apply your own reasoning.
4. To keep an open mind. Think about crazy things. Test them by asking challenging questions. The answers are less important than the thought processes they revealed.

Warning: Watch out for US dollar exposure in commodities trading

One word of warning on commodities. Since they are usually priced in US dollars, price moves can sometimes have more to do with dollar strength or weakness than with commodities.

In periods of dollar weakness, for example, commodity prices may rise just to keep their European and Japanese price relatively stable.

This is always an important consideration if you do not want to accidentally speculate on currencies.


Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading

The recent commodity story has been all about China

A new period has emerged over the last few years. Growing economies, particularly China, have experienced strong growth and inflation simultaneously. They have tolerated inflation, and let growth rage on. Commodities have had a renaissance. There has been debate about whether China will try to cool inflation, but in the meantime, commodity prices have soared as the hungry dragon searches the world for raw materials.

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For instance, you could have bought Australian dollars in 2003 as a kind of commodity play.

• The widespread view then was that Chinese demand for commodities would drive prices higher, and that Australia was well placed to benefit as a supplier.
• There were other things in favour of the Aussie dollar, such as strong growth and relatively high interest rates, which gave added confidence.

You would have done well during this perid, given the usual lacklustre environment for trading in commodities.


Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading

Long periods of high growth and high inflation are rare

To invest into commodities, you can choose to buy:

• individual commodity
• existing commodity index (basketo of several commodities)
• companies, such as steel or oil companies, which will benefit from higher prices of their products, or,
• the currencies of countries which have a lot of natural resources

The best time to do so is when inflation and economic growth are both strong.

In practice, though, there have not been many periods where growth and inflation are able to rise at the same time.

• Authorities normally respond to higher inflation by raising interest rates. They only have difficulty keeping a lid on inflation if raising rates weakens the economy too much.
• When there is strong growth, the authorities have a lot of room to move without causing a recession, and so they are able to stamp down on the inflation if necessary.
• Therefore, it has been rare to find long periods of high growth and high inflation.
• (This helps to explain why commodities have seen a 50 year or so price decline in real terms.)

CRB Index since 1950:

In the 1970s:

• there was high inflation, largely caused by OPEC, without strong economic growth.
• Commodities has their best run for a long time but prices still barely rose in real terms, because inflation caused a tripling of average price levels.

In the 1980s and 1990s:

• saw the opposite experience, with falling inflation and many periods of good growth.
• This was miserable for commodity prices in real terms. The economic growth was not enough.
• The increased demand by the growing world economy was generally offset by falls in the costs of production and extraction due to dramatic improvements in technology.
• Technology also helped economies reduce their dependence on the more expensive commodities, such as oil.
• Social changes also reduced the growth in demand for commodities, as economies became more service oriented, and less reliant on manufacturing.

Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading

CRB Index

While you can choose your own selection of commodities, it is probably easier to use an existing index. The most watched indicator index is known as the CRB index.

Future and options on the CRB index are traded on the New York Board of Trade. It is made up of different categories of commodities:

• Energy: crude oil, heating oil, natural gas
• Grains: corn, soybean, wheat
• Industrials: cotton, copper
• Livestock: cattle, hogs
• Precious metals: gold, platinum, silver
• Softs: cocoa, coffee, orange juice, sugar

Because it covers such a diverse range of materials, its movements will mask moves in the individual components, and smooth out the supply problems. Obviously, there are many other commodities which are not included int he CRB index.


Alternative methods

As an alternative to trading an index on an exchange, there are a number of different ways to trade commodities - apart from keeping silos full of corn in your backyard.

• You can also invest in companies, such as steel companies or oil companies, which you feel will benefit from higher prices of their products.
• Or you can even go a step bigger, and buy into the currencies of countries which have a lot of natural resources.

Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading

Trade in a basket of commodities

The strategy to adopt will probably be to trade a basket of several commodities, rather than any specific item. This is because to get the net effect of growth and inflation, you will need to remove a lot of the randomness in the price caused by supply factors.

These supply driven commodity markets can present extra difficulties. These markets are often turbulent.

• They can be influenced by events in remote countries, many of which can be unstable and corrupt.
• They can also be influenced by the random effects of the weather. You don't want your view that higher inflation will cause higher commodity prices to be upset by good weather causing a bumper crop in bananas.

Most of the information driving commodities can be quite obscure. It is a difficult task for investors to somehow get hold of that information. So by trading a basket of commodities, you will win some and lose some on the individual items, and allow the economic fundamentals to dominate. You would rather do that than bet on whether there will be a bad season in an unpronounceable country.


Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading

Buying commodities. When?

Buying commodities when inflation and economic growth are both strong

Commodities are raw materials. Economic growths is good for commodity prices because a growing economy needs more inputs. Inflation is also good for commodity prices because commodities are tangible assets rising in price as the value of paper money declines.

Like all markets, the commodity markets have some large moves driven by a consensus on the fundamentals, which drive the price further than generally expected. So the idea here is to identify those periods where growth and inflation are strong, and then to take a long term view with a trading position.


Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading

Few assets benefit in stagflation

A combination of inflation and slow growth rarely helps any asset class. We had almost a decade of this in the 1970s, and stock and bonds suffered miserably. Even commodities struggled to rise in real terms.

1970s - a miserable decade

OPEC hit the world with two oil price increases. In 1973, the price per barrel went from a few dollars to over ten dollars, and in 1979 from the low teens to over 30 dollars. The west was far more dependent on oil than today.

The oil price fed into just about all prices, and inflation went out of control. By 1980, it was around 10%. People were accustomed to cycles in the economy. Normally, inflation would only rise when the economy was doing nicely and it was the excess demand that pushed up prices. However, in the 70s, jobs were scarce as unemployment also headed towards 10% and so there was plenty of unused capacity in the economy. This was inflation plus stagnation, and they had a nice word for it: stagflation.

No one knew what to do about stagflation. Australia tried wage freezes. Unions were more powerful then, and tried to ensure their members' wages were maintained. In the UK, they had 'the winter of discontent' and things became so bad that they were ready for the dose of medicine called Thatcherism.

No easy answer to stagflation

However, what could the authorities have done? A rise in the price of oil is like a tax on the entire country. Just about everyone is going to be worse off.

Unfortunately, there is no easy policy the authorities can adopt to fight stagflation. The economic theory has done a lot for economic management in normal conditions. The greatest economist ever, John Maynard Keynes, told us what to do: increase and decrease the government budget to smooth out the economic cycles. When people are not spending, governments should do the spending for them, and borrow the money. How insane were governments to reduce, rather than increase, government spending in the Great Depression! On the other hand, if people are spending too much and the economy is overheating, governments should cut back.

Keynes did not really trust interest rates as an economic tool. One reason was that in a recession, an interest rate cut may not be enough to encourage overly pessimistic consumers and businesses to borrow and spend. You can only lead a horse to water. But again, in normal conditions, interest rates can be used very effectively. When inflation rises, a little tightening up of interest rates slows things down a little, and the inflation eases off. This method of controlling the economy has become even more important as politicians have hijacked the fiscal budget for politics, rather than economics.

The trouble with stagflation is that the authorities don't know whether to boost the economy or to slow it down. Trying to create jobs risks even higher inflation, and trying to solve the inflation problem makes the job situation even worse. So it is not clear what to do with the budget balance or with interest rates.

These problems for the economy and the policy makers are reflected in the markets, and there is nothing attractive to investors. All you can do is to stay in cash, and to sell the other markets.

The stagflation of the 1970s only really ended when the US Federal Reserve gave the economy a sharp dose of very high interest rates in the early 1980s, and allowed a recession. Hopefully, we will not get another decade like the 70s for a long time.

Quality of company's management in determining its success

The quality of a company's management is by far the most crucial factor in determining its success

You have seen bad management mess up the most amazing opportunities where companies have failed despite having everything else going for them.

Often, the investor made many mistakes by focusing too much on the product, and not enough on the management. Good management will find a way to make their product work, while poor management can mess up good products.

Even big companies can make mistakes. Xerox had a fantastic product in photocopiers in the 1970s. They had a fantastic platform to expand into the technology market, by developing printers and similar devices, yet a few years ago, the company was struggling for survival. They've had a very tough time after never really grabbing the opportunity. It does seem to have been a management problem.

On the other hand, good management can often build something out of almost nothing. They are good at developing the business in the right direction. They spot opportunities, and have creative solutions. If their products are not selling, they may find ways to improve the product by research and development, or by buying or merging with other companies. They can weed out the wrong people and they face up to difficulties early.

It is easier to assess the management of smaller companies than larger ones.

There is a much greater variation in the level of talent within smaller companies. Just about all managers of big companies are very talented, even those who fail. Unfortunately, for smaller companies that is not always the case.

During the tech wreck, many small tech companies fall while others somehow survive. The survivors generally had good management. They weren't necessarily those with the best product, but they were those that cut expenditure when times were getting tough, and made plans for keeping the business alive for three or four years until the market recovered.

The track record of the managers is also very useful. Sometimes the managers are very appealing because previously they have taken a company all the way from nothing to good valuation. They may have built up a good reputation and made money for themselves in the process, and you know that they have choices apart from working for the company in which you're potentially investing.

Management strategy can also reveal a lot about their quality. Many investors focus too much on current revenue and profits while ignoring strategy. It's this that can be vital to a company's future, particularly with smaller companies that have fewer resources to recover from mistakes.

The fundamentals had changed and the trend may not be your friend

"I didn't invest in this or just about any other tech company in the final twelve months of the boom, and I tried where I could to sell my tech investments. I had been investing in tech since 1995, but, to me, the fundamentals of the tech sector had changed. The quality of new tech companies had dropped tremendously and they were being funded with a lot of cheap money from naive investors."

The above investor made his decision despite the fact that share prices in the tech sector were trending straight upwards and that decision saved him a hell of alot of money when the crash came.

The tech crash is a great example of where fundamentals are the most important consideration, and where the trend may not be your friend. The strategy here is to monitor the fundamentals and to cut positions accordingly, even if the trend is still in your favour.

If the fundamentals have changed, adjust the position accordingly.

The 3% rule for wealth preservation

If you want to maintain your wealth in real terms, you can probably spend no more than 3% of your capital each year.

The idea is that real interest rates are generally around the 3% level. At the moment for instance, five year rates are roughly 5%, inflation is roughly 2%, and that leaves you 3%.

Now you may think that you can earn more than the 5% offered by interest rates. Investing in the share market for example, has outperformed interwst rates over the long term, so that could help. But by trying to do better than interest rates you will also risk losses. The share market can be volatile with long bleak periods for investors who move away from low risk investing. The other problem of course is tax.

The fellow who won the lottery could probably have counted on earning $30,000 per year in real terms if he had invested the entire $1 million. That is probably less than his job was paying. So even though he feels rich, and all his friends want a loan, he may struggle to live off his capital. He would need to be frugal; perhaps the cars and the studio weren't such a good idea.

The task of just maintaining wealth is a challenge for many people, not just those lucky in the lottery. The era of low risk, high returns of over 10% is over for the moment. Those days are gone and wealth preservation is more difficult.

With success, bank some profits

If the fundamentals continue to look good and are supported by a favourable price trend, do not take profits.

However, if you are doing particularly well, you should cut winning positions to keep a balance in your portfolio and take cash out of the market.

There have been some very high-profile billionaires who have gone completely bust. They probably took a lot of risks to get there, which were too bold for most people. Why didn't they just put a lazy hundred million on the side, in case it all went horribly wrong?

Here is a sensible way to lock-in some wins.

Value all of your positions on the basis of the current market price. This process ignores your original entry price, and any other price along the way, such as a high or a low.

If your investments are going really well, you may find that their mark-to-market value significantly exceeds the original risk amount you had in mind.

As an example, say you, allocated 20% of your assets to trading, and the positions have done so well that on a mark-to-market basis, they are now worth 40% of your total assets. Here you should probably reduce your positions and bank some profits. This would even be regardless of supportive fundamentals and a trend in your favour.

Over the years there were times when an investor or trader reduced positions which were doing well and which looked good going forward. Those decisions had nothing to do with their views on their fundamentals, but were simply to take cash out of the market.

Exiting a winning position for traders

A reliable way to exit a winning position with good fundamentals is to allow the price trend to finish. This demonstrates that the idea has run its course. The price reaching an arbitrary target or a period of time elapsing is not a reliable signal. Even if a trade is doing well, keep an eye on those fundamentals.

You will never have the satisfaction of getting the best price or the biggest possible profit. If the fundamentals remain the same, wait for the trend to turn, before getting out of a winning position.

Buy and Hold - may have had their day

Buy and Hold mantra

One popular theory is that investors should buy and hold their stock investments. They should not try to outguess the stock market. This idea became a mantra after the market recovered so well following the 1987 share market crash. The crash now only looks like a hiccough from the great bull market of the 1980s and 1990s. That recovery was a manifestation of the market's long term resilience.

A related theory is that the stock market should always outperform bond yields over the long run, as stock investors are compensated for the extra volatility.

These types of theories may have faded a little now, after global investors experienced the bear market in 2000 and the recent 2007-2009 severe bear market. In the US, the broad stock market indices closed lower in 2005 than five years earlier. Five years is a long time, even for patient investors.

As the buy and hold theories have become widely held, the effect has been to push prices higher, increasing the entry cost for new buyers and removing their attraction - a kind of self-defeating prophecy.



Using PE ratios

Other theories, based on ratios, such as PE ratios, would have been very effective in signalling the tech crash a few years ago. However, using this would have made many investors over cautious, and missed much of the fantastic bull market in the five years earlier. That would have cost investors a large amount of missed profits. (Caution!! Maybe risky strategy.)



In summary

Choose the best periods to be invested in the stock market. There are long periods of over and underperformance.

Watch the economy and the big picture influences.

The best way to time investments is to allow some broad consensus to build in the market and invest after the price begins to move. (For example: There is a consensus building that the worse of the recession is over and the world economy is heading towards recovery. Moreover, the prices have moved.)

Crisis situations almost always provide an opportunity

Don't buy into falling markets. The occasional successes will not pay for the more numerous failures. The falling markets can surprise many of us by how far they move. Recall the recent 2007 -2009 severe bear market and those who bought big and get caught in the falling market. Among them, Temasek, Oei Hong Leong, the German industrialist who committed suicide for betting on a auto stock, and others.

Panics can lead to an imbalance in supply and demand

Nevertheless, there is an exception: crisis situations. In crisis situations almost anything can happen because there is panic in the markets. You see the most controlled and sensible people completely lose all their judgement when they are under intense pressure. Sometimes the whole market is awash with nail-biting investors and traders, feeling nervous and confused. With the volatility we have experienced the last 25 years, there have been many such episodes. The share market crash of 1987, the emerging market crisis of the late 1990s, the tech wreck, and 9/11 are just a few that come to mind. And, undoubtedly, there will be many more.

The reason that there are opportunities on these occasions is simple: a falling price triggers more panic selling than it does bargain-based buying.

During these crises, many players will be forced to cut their positions regardless of the price. Some funds will have lost so much money on many different investments, that their very survival would be threatened if they lost more. They may reason that by selling, they take a dreadful loss, but at least it does not put them out of business. Even though holding on may be a great trade, they simply cannot take the risk. There have been many instances of a senior manager ordering a fund manager to cut, and ignoring their heartfelt plea not to do so.

At this point fresh buyers could come into the market looking for value. However, at times like these, potential buyers may be too distracted with their own problems to do anything. This particularly affects smaller markets since fewer people are watching them anyway.

Suffering from this lack of buying, the market could paradoxically be struck by new selling. Some hedge funds and other momentum players may ignore fundamental valuations and see selling as an opportunity, as they look for the price to go even lower.

While all of this is going on, you may be able to step in. Hopefully, you will have followed good risk management so that you yourself are not facing a crisis, and you can keep a cool head even as others panic. You should be extremely choosy over how you get involved in the market - try to consider many different opportunities and don't necessarily jump at the first one you see. In a genuine crisis, there will be no shortage of ideas.


Ref: 100 Secret Strategies for Successful Investing by Richard Farleigh

Pros and cons of using stop-losses

Here are two episodes to illustrate the pros and cons of using stop-losses:

Cons

"So, in December 2003, I invested in the company at an effective price of 90 cents, which implied a market capitalisation of about $220 million. Over the next six months the price had a strong trend - downwards. In July 2004, it fell to as low as 55 cents.

This was around the stop-loss level I had in mind when I invested.

There didn't seem to be any reason for the dramatic fall. Everything seemed to be going on track for the company. The network was being set up, trials of the system were progressing and the modems they had ordered were being delivered.

Here was a classic stop-loss dilemma. If I had thought that there was any way the price would drop so severely, I would not have invested. The fundamentals were sound, so if anything the company was a buy at this price, rather than a sell.

I held on to my investment. Since I had quite a large position, I didn't buy any more. Fortunately for me, the price recovered as the company achieved some success with its product launch in August 2004 following a strong advertising push. That sent the price to over $1.10. I later exited my position at around $1.00, when I became worried about potential competition emerging from other companies."

Pros

"I had a tough experience with my ARC shares, where cutting a deteriorating position would have been the better choice than hanging on, and where clearly I was stressed and lacked discipline - exactly the problems that a predetermined stop-loss strategy seeks to avoid. "


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In the first episode, the investor did not use a stop-loss, and the market recovered allowing him to salvage a small percentage profit. His confidence was rewarded.




Summary on stop-loses

Have a stop-loss in your mind when you invest and if the price hits the stop-loss level, always cut if:

• the loss is threatening to be destructive;
• you are confused about what is going on; or
• the fundamentals are moving against you.

You should only keep the position and consider increasing it if you remain genuinely confident about the underlying fundamentals. Experience will help you recognise when you are starting to rely on nothing but hope. If you do stay in, choose another stop-loss level as a reference point, and stay disciplined.

You should also manage risk by not betting too much on one idea and by anticipating market moves twice as big as seem reasonable.