Why the Fed's Decisions Won't Help Your Portfolio
By Chandler Lutz
September 18, 2007
If you’ve been anywhere near a television or computer recently then you know about the Fed’s big interest rate cut. News channels have experts on telling you how this interest rate reduction will affect the economy and what it means for the housing market...but do the Fed’s actions really help your portfolio? Are Bernanke’s changes really going to make your investments substantially better over the long term? These may be tricky questions for some people, but for most of us the answer is no? Ok, I know you’ve checked your portfolio and you’ve made an extra two to four percent on the day, but is that really a big deal? After all, the Fed will probably do something Wall Street doesn’t approve of sometime in the future which will offset any gains he just gave you.
Aside from the short-term gains, how else does this interest rate cut affect your portfolio?
Let’s first look at the negatives:
With all the market increasing so drastically a lot of companies that were once bargains may not be so anymore. Actually, for all intensive purposes Warren Buffett hopes the market plummets so he can find more companies at good prices. With the market rising this is much harder to do. As a matter of fact, I sat around this afternoon watching CNBC waiting for the Fed’s announcement. I was hoping that Bernanke would leave rates alone (or maybe increase them) so the market would drop 400 points and I could buy stocks at bargain prices. Needless to say, that didn’t happen and I rumbled around disgruntled for the rest of the afternoon.
Now we’ll look at the positives:
(1) Businesses with tons of debt may be able to barrow at cheaper rates. If you are looking at a debt ridden business, a cut in interest rates is definitely favorable. However, if the company has so much debt that a cut in the interest rates will actually be a part of your investment thesis then you may want to reconsider the investment quality of that particular firm. Most high-debt businesses run into trouble when things stop going their way. Granted there are great businesses out there with debt on their balance. These may be perfectly legitimate firms. The problem arises when firms need to rely on something like an interest rate cut to help them through their troubled times. A perfect example of this is the Ford Motor. With $170 billion in long term debt, this fall in interest rates may make a significant impact on the company’s balance sheet which only evinces the fact that the legendary automaker might not be that strong.
(2) Companies that sell durable goods may get a jolt in earnings because of an increase in consumer spending. For those firms out there that are selling such things as cars, houses and refrigerators; this cut may mean a lot to the bottom line. The problem is that the market has already incorporated in a lot of the potential upside into stock prices. For Example, the Dow Jones Transportation Average was up 3.92% on the day of Bernanke’s inaugural interest rate cut while the Dow Jones Composite Index was up a mere 2.82%.
(3) The Fed’s Actions may keep the economy out of a recession. Since there is no way you can predict a recession, there is no point in worrying about it. Great companies will perform well regardless of the market’s performance (unless of course you are investing in cyclicals). If the company does well, the stock price will eventually follow.
The whole reason the Fed makes interest rate increases and decreases is to ensure that the US economy remains on a steady solid path. If the Fed is successful in his endeavors, it may not be the best thing for your portfolio since the stock market always performs its best coming out of recessions. The market went on a tear after the 2001 recession and after the 1992 recession. Also, if a recession occurs there are more bargains out there compared to the times of economic expansion.
So, what do you in the mist of all this interest rate madness? Nothing. There is no way you can predict the direction of interest rates perfectly, so why bother? Also, immediately after an announcement is made an army of Wall Street economists are waiting to decipher the data. So any potential gains become immediately discounted into the stock price. Additionally, Warren Buffett said that he never makes an investment decision based on changes or potential changes in interest rates. I think we should listen to the master and turn away from the interest rate insanity.
Chandler Lutz does not own shares in any of the companies mentioned
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