The correlation between shares and interest rates | Fin24
 
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The correlation between shares and interest rates

Jul 30 2019 08:14
Schalk Louw

General consensus is that the interest rate cut earlier this month won’t be the last decrease of the year.

I often write about the correlation (or lack thereof) between a variety of ratios and investments.

What an investor should be interested in at this stage, is how it would affect local shares if interest rates were to decline even further.

As an example, let’s refer to the period between 1973 and now, bearing in mind that the past in no way guarantees any future movements.

(See the table below, indicating movement from 1991 onwards.)

The period during which interest rates begin to rise from a low up to where they start to drop again, is called a rising interest rate phase.

When interest rates drop from a high to a low, the period up to the point where they begin to rise again is known as a declining interest rate phase.

What’s interesting about this almost 46-year period, is that interest rates were rising about 51% of the time, and declining around 49% of the time. 

JSE during different interest rate cycles

graph

Source: PSG Wealth Old Oak & Iress 

This is very close to a 50/50 scenario.

Even more interesting is the duration of these phases. They didn’t only last for a month or two. An average rising phase lasted for 31 months over this period, while an average declining phase lasted for 32 months.

When we look at the stock market during these phases, it’s quite striking that we never saw a negative market during a declining interest rate phase since 1973.

On the contrary, the market flourished.

The average growth during a declining interest rate phase over this period was an incredible 29.5% per year, while you only would have earned an average of 0.9% growth per year during the rising interest rate phases.

Investment return when only invested in JSE in a declining interest rate cycle

graph

Source: PSG Wealth Old Oak & Iress

The remarkable thing about this theory is that if you had invested R100 only in shares in March 1986 and you withdrew all dividends, your investment would be worth R4 416 today, compared to R2 388 (before tax) in a money market investment.

But if you invested only in shares during a declining interest rate phase and then took refuge in the money market during a rising interest rate phase, your R100 original investment would be worth a staggering R14 961 today.

Of course, it is important to point out that the past bears no guarantees for future performance. In light of this, I need to make it clear that it is never a good idea to place all your eggs in one basket.

I am also not trying to encourage you in trying to time the market.

But this does point to something important: Often, when investors are ready to give up on the stock market, it may in fact be the best time to invest.

South African companies have had a very tough time over the last five years and, in the process, have managed to position themselves very cost-effectively. With interest rates back to lower levels, there certainly is reason for optimism.

Will this time be different? Will this be the last interest rate decrease South Africans will see in 2019? Are shares currently priced exorbitantly following the past seven month’s positive run?

My answer to all three of these questions, is that I think not.

But whether you believe in historical movements or not, the correlation between shares and interest rates cannot be denied.

Schalk Louw is a portfolio manager at PSG Wealth.

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