Computerized Investing is a column in the AAII Journal that covers articles about how individual investors can use digital technology to become more effective managers of their assets.
Snapshot of a Stock: The Balance Sheet
Successful investing has no secret formula. Since financial statements are basic tools of fundamental analysis, it is important to be able to read and analyze them.
The stock market crash of October 1987 was highly dramatized in the media. But during that year, more money was lost in long-term bonds and bond funds than in stocks.
Interest rates fluctuated widely throughout the year, then rose dramatically by the end of that year. This caused the bond market to lose significant value.
Why?
When interest rates rise, market values of existing bonds drop because their interest rates are fixed and the present value of the bond's stream of interest payments fluctuates. These factors caused investors to panic and sell their bond funds, leaving fund managers with no choice but to sell these long-term bonds at depressed prices as a way to generate cash for redemptions.
The 1987 bond market crash dramatically illustrates the market price risk of bonds and bond funds. However, there are actually four main risks inherent in every bond and bond fund:
I have frequently been asked, “What is the one thing an investor should monitor in order to gauge the health of the economy and the direction of the stock market?”
My response is “interest rates.” The mandate of the Federal Reserve is twofold: to promote economic growth and to keep inflation under control.
Think of it this way. If the economy were a car, the Fed’s responsibility as a driver would be to maintain a safe speed. If the Fed wanted to speed things up, then they would step on the gas by lowering interest rates. To slow things down, however, the Fed would need to tap or even slam on the brakes by raising interest rates and reducing the availability of capital.
The biggest challenge for the Fed is that our economy isn’t a little red sports car that reacts nimbly to the application of the gas pedal or the brakes. Instead, the economy is more like a supertanker whose response time is remarkably slow. It usually takes between six and 12 months for the economy to feel the stimulation effects of lower rates. It also takes quite some time for the economy to slow down as a result of higher rates.
In the current market environment, the equity market’s response time has been even slower than normal, despite the Fed’s rate reductions and unprecedented stimulative actions.
One reason could be that the recession and bear market were the result of higher energy prices, a worldwide credit crisis and a general crisis of investor confidence, not the result of higher interest rates. As a result, lower rates alone haven’t reversed the damage done to the economy and equity markets in the past 18 months. However, the Fed’s unprecedented efforts to loosen credit markets,...
