Do You Have an Exit Plan?
By Saghir Aslam
Rawalpindi, Pakistan
(The following information is provided solely to educate the Muslim community about investing and financial planning. It is hoped that the Ummah will benefit from this effort through greater financial empowerment, enabling the community to live in security and dignity and fulfill their religious and moral obligations towards charitable activities)
When two objects collide, the object with the greatest momentum will prevail, or so reasoned Sir Isaac Newton in 1687.
Today, the coming collision of two opposing economic forces will have a strong effect on the way portfolio managers make investment decisions.
The two forces are the New Economy and rising interest rates.
On February 8, the Labor Department reported that productivity in the fourth quarter of 1999 grew by a sizzling 5%. For the full year, productivity grew at 2.9%, the strongest one-year figure in seven years.
The kicker was that while productivity was growing at a record rate, labor costs actually fell 1% in the fourth quarter, their largest fall since 1996.
High productivity and falling labor costs are the heart and soul of the New Economy. These figures indicate corporations are automating to get more production with fewer employees. That trend neuters the argument that the shrinking labor pool will lead to inflation.
In this type of economy, managers typically favor large-cap growth stocks that hold the promise of galloping future earnings. Today, the market is obsessed with one segment of the growth area: tech stocks, particularly stocks that have anything to do with the Internet or its infrastructure.
But interest rates are rising, not falling. When the Fed raises rates to 5.75% from 5.50% this month, it was the fourth quarter-point increase since June of last year. Rates have not been this high since July 1995, and more increases are likely.
This could be the flip side of the New Economy, because productivity is unlikely to stay strong if rated keep rising. In a high interest rate environment, value stocks are favored over growth stocks, the opposite of the pattern prevailing today.
So it appears that rising rates are heading for a bumper-to-bumper collision with the New Economy. Right now, the New Economy is traveling at warp speed, squashing interest rate hikes like a steamroller passing over an ant.
But this could change if rates keep going up.
Are fund managers worried about the upward pressure on rates? You bet they are, and they are planning the strategy they will use if rates continue to soar.
Some of the managers have an exit plan. Even though rates are already high, they could go a bit higher without changing growth strategies.
How much is a bit higher?
The safe zone is 6% or 6 ½%, but 7% would take us out of that safe zone and change the way the economy is favoring growth stocks right now.
With a fund laden with tech stocks, what would we do? Be careful and stay in cash. The safest place to be would be in cash until rates came down again?
The Fed brings rates up and down slowly, always by a quarter-point each time, and that seems to be working. Bob Froehich, managing director of $110 million Scudder Kemper Investments, agrees that 7% is the threshold at which his view of the market would change. If rates went to 7% and stayed there, we would have a fundamental shift out of equities. In the stock market there would be dramatic rotation out of growth stocks.
Many small-cap companies would gain an advantage if rates hit 7% because they would gain an advantage if rates hit 7% because they would be able to raise their prices and increase revenues. If we run into inflation, I would just keep buying the best small caps I can find. While investors scrambled for 7% bond returns, some equity managers would start looking for stocks they believe are immune from the ravages of steep rates.
As you can see, interest rates play a major role in stock prices. As interest rates rise or fall we must watch them very carefully, particularly for short term investments.
(Saghir A. Aslam only explains strategies and formulas that he has been using. He is merely providing information, and NO ADVICE is given. Mr Aslam does not endorse or recommend any broker, brokerage firm, or any investment at all, nor does he suggest that anyone will earn a profit when or if they purchase stocks, bonds or any other investments. All stocks or investment vehicles mentioned are for illustrative purposes only. Mr Aslam is not an attorney, accountant, real estate broker, stockbroker, investment advisor, or certified financial planner. Mr Aslam does not have anything for sale.)
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