In order to establish a long-term investment strategy, it is crucial for the investor to closely follow the current level of real short-term interest rates. We have seen that if real short-term interest rates are below 1.4, or short-term interest rates are considerably less than twice the level of inflation, the following conditions are likely to happen in almost any country.
• Rising inflation
• Rising commodities
• Volatile economic and financial cycles
• Very low productivity growth
• Very poor economic growth
• The tendency of corporations to raise prices rather than invest to improve productivity
• Low investment in technologies
• Soaring real estate prices
• Soaring land prices
• Rising art and coin prices
• Soaring long-term interest rates and sagging bond prices
• Soaring short-term interest rates
• Frequent protracted declines in stock prices with equities declining 20 to 40%

On the other hand, the above trends are reversed when real short-term interest rates are close to 1.4 or above this level, or short-term interest rates are close to two times the level of inflation.

The message of this chapter is that interest rates, their level and their trend, represent an important element to guide your investment strategy. Their careful interpretation provides a useful tool to develop a successful investment program. Higher than average real interest rates tell the investor that policymakers are determined to keep inflation under control and therefore maintain stable economic conditions. These economic conditions are usually associated with a strong currency. These are ideal times to invest in financial assets (for instance, bonds and stocks) and avoid hard assets (real estate, art, coins, precious metals and commodities). Furthermore, if short-term interest rates are close to 5-6%, the markets are confirming that the policies followed in a country are sound and there are no problems on the horizon.

If real short-term interest rates are very low, or worse, interest rates are below inflation, the implication is that the country is in serious trouble and monetary authorities are following an easy money policy to hide the problems. This is achieved, as will be discussed in the chapter covering the Federal Reserve and Central Banks, by letting the money supply grow very rapidly and keeping real interest rates very low. The odds favor higher inflation, higher commodities, unstable economic conditions and a weak currency. Investing in hard assets is the investment strategy that would likely be successful in this environment. Last but not least, avoid investing in countries with weak currencies. Always give preference for countries with strong currencies.

As the reader is beginning to realize, there are many forces that impact investment strategies. The trend in the economy, its growth, and its momentum, are the major determining factors. The level and trend, not only of interest rates, but also of real short-term interest rates and long-term interest rates provide crucial clues on the risk and opportunities of stocks and types of assets to be invested in. High and low real interest rates are driven of course by monetary policy. This will be discussed in great detail in the next chapter dealing with the Federal Reserve. That is one of the most crucial parameters for developing an investment strategy. The trend in stock prices and of the currency reflects all these forces. For this reason we will place the analysis and investment in stock prices as one of the last chapters after having analyzed all the forces that have a profound impact on their trend.

But first we have to explain how the Federal Reserve or the central bank of a country impacts the growth and liquidity and the level of interest rates. Then we will see how the action of the Fed translates into trends in commodities and inflation. We will then be ready to look at investment in bonds, and finally we will examine how the stock market is impacted by all these factors and develop some guidelines to minimize risk in portfolio management.

(From Chapter 5 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China. The book is available at Amazon.com).

George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager

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