Interest Rates and Inflation

Interest Rates

• A rise in interest rates (for example, to 12%) make other investment alternatives, as the stock market, unattractive to the majority of investors. Why put money in a system that is prone to business risk and economic downturn and get a return of 10% when you can get 12% risk free (i.e., the “risk free rate”)? Most people would opt-out of such a situation.
  
• With more and more money being removed from the market and invested into savings accounts the trading volume in the stock market decreases significantly – creating some wonderful buying opportunities.
  
• Thus, with the rise in interest rate people tend to become “savers” as opposed to spenders and investors in times of low interest rates.
  
• The mortgage/savings & loans (SNLs) or banking industries usually experience a slow down. This is because interest rates are so high (like 12%+) that people tend to borrow less in business loans, car loans, mortgages, etc… Therefore, the banking system’s profits tend to decline as more and more people start pulling money out of investments and “saving” it.
  
• This usually leads to a recession which is where bear markets are given birth – the perfect opportunity for sophisticated investors.
  
• To revive the economy the chairman of the Federal Reserve (currently Allan Greenspan) lowers interest rates, sometimes to decade lows.
  
• The corporate world adds to the solution by starting the lay-off process to increase their “tight” profits further. These lower profits are the result of lower sales revenue which was caused by massive savings on the part of consumers due to high interest rates.
  
• The market, which had already started its decline due to low volume, tends to plummet further on the bad news of corporate budget cuts, lay-offs, stalled profits, etc... This creates the opportunities for investment dreamt by the true investor, as stocks which traded at P/Es of 50+ are decimated to the single-digits to low-teens.
  
• Once the Fed reduces interest rates people being spending and “investing” once again.
  
• Since interest rates are low people are easily seduced into mortgaging homes, taking out business loans, car loans, and start “investing” back into the stock market.
  
• However, they do not chase the once hot tech stocks this time. Those stocks are dead until the companies start generating earnings. This time they put money in famous blue chips like Proctor & Gamble.
  
• The fast growers that were successful before the recession/market correction are where the unearthly profits will come from, and the true investor knows this.
  
• The market starts its recovery and then, once again, bubbles. The sophisticated investor gets out at the right time, and waits for the process to repeat itself. That is, the process of buying low and selling high because of an economic downturn coupled with bad news about the corporate world portrayed by the media.
  
• The bottom line is that there is an inverse relationship between interest rates and the stock market. When one goes up, the other goes down.

Inflation
Inflation is the general rising of prices throughout the economy. The true investor is an expert at staying many percentage points above this economic dilemma. This is because the true investor invests in businesses that can raise the prices of their goods and services along with inflation.

Therefore, inflation actually makes the investor “richer” as the company he/she invests in can generate twice as much profit due to their monopolistic control over price.