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Saturday, July 19, 2008

How you can stay ahead by being interested in interest

After a couple of posts with strong technical overtones, it is time to clear the air that I am also interested in fundamentals.

Interest rates are a 'leading' indicator. That bit of profundity means that interest rates usually change direction before the stock market does. Some times this can happen several months ahead of time and some times it happens shortly before.

Back in 2002-03 (if you can remember that far back!) when the stock market was in the doldrums, the returns from debt mutual funds were so good - upwards of 15% - that a certain foreign bank's mutual fund division didn't even bother to have an equity fund in their portfolio!

Then the interest rates started falling and by the time they woke up to the fact that equities had started picking up, they were way behind in performance. They finally came out with some equity funds - one of which performed pretty well - but the bank's mutual funds division had to be sold off.

The situation had drastically changed by 2007 when interest rates started moving up again. Conservative Indian investors started moving money back into bank fixed deposits and inflation hadn't reared its ugly head. However, that was the first warning sign that the stock markets were going to be in trouble.

Why? Because most 'punters' (the gamblers who play with derivatives) bet with borrowed money - many a times loaned by their brokers. As interest rates move up, their cost of doing business goes up and makes the margin of profit minimal.

The higher interest rates also have a cascading effect on the economy - particularly in interest-rate sensitive sectors like banks, automobiles, real estate. The cost of doing business goes up for all of them. Less people take out loans at higher interest rates, so they hold back on their vehicle and apartment purchases.

To top it all, the huge run up in oil prices pushed inflation up - causing the Reserve Bank to raise interest rates even further to curb inflation! Then the FIIs started to depart. Talk about a 'perfect storm'!

So when will the nightmare end? A necessary - but not necessarily sufficient - condition is when interest rates start moving down again. That will be the first sign that the market may start to turn back up. It doesn't look like that is going to happen in a hurry - so be prepared for a long drawn out bear market - but keep your eyes and ears glued to the RBI pronouncements.

Just a positive note amongst all the gloom and doom. I tried to practice what I preach by going out and making small purchases in a leading Balanced fund and one of the top diversified equity funds on Thursday morning (the day after the market had made a 15 month low).

Does that mean that I think the market has touched bottom? Not really. No one knows that. But any time that the Sensex closes below 13000 provides opportunities to make small purchases.

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