- Money Morning Australia

The Primary Colours of Investing


Written on 28 February 2013 by Kris Sayce

The Primary Colours of Investing

Two things move markets.

That’s right, only two things.

You wouldn’t know that from all the fluff you see in the mainstream.

Based on what you read elsewhere, we would forgive you for thinking that markets (including stock markets) are much more complicated.

The truth is you don’t need a physics, maths or engineering degree to understand it all.

You just need to know the two things…just two things…that move markets. If you get that you’re well on your way to understanding how and why markets move, and how you can potentially profit from those moves…

We know our colleagues in the financial services industry won’t like this, but investing isn’t difficult.

It’s not like performing open heart surgery, taking apart and fixing a car engine, or building a house from scratch. That’s tricky…and it’s why you won’t find your editor tackling any of those tasks.

As far as stock investing is concerned the only two things you need to look for…the two things that move markets…are interest rates and earnings.

If you break everything down to the base elements, you’ll find that everything results from these two factors. You can call them the primary colours of investing

The Importance of Investing’s Primary Colours

We did some fishing around earlier this week. The amount of meddling in financial markets has created a lot of confusion for investors.

The most confusing has been the amount of money printing and interest rate meddling.

Just yesterday we posted a link on our Google+ page to a Daily Mail article. The article suggests the Bank of England could move to a negative interest rate environment. That simply means the Bank of England would charge banks to hold cash at the Bank of England.

Why would they do that? The idea is that if banks hold cash at the Bank of England it means they aren’t lending it to consumers and businesses…and that’s why the economy is in recession. The charges would deter banks from holding cash at the Bank.

Of course, that’s not the reason for the recession. The reason is that there has been too much credit for too long. The economy needs to readjust.

A recession is simply the economy telling people it’s exhausted and needs to stop growing…the Bank of England is trying to ignore that.

But let’s break that down. What’s at the core of this issue? That’s right, interest rates and company earnings.

This link is the key to how an economy will perform. The thing is over the past few years the link between interest rates and earnings has flipped. And investors better get used to it, because it isn’t going to change…

The Key Chart Explains it All

One of the things we wanted to find out was the link between interest rates and earnings. The best way to show this (in our opinion) is to show a chart of interest rates and dividend yields (earnings paid to investors).

The chart below shows you the Reserve Bank of Australia (RBA) Cash Rate (blue line) from January 2000 through to February 2013. The red line is the dividend yield for stocks in the All Ordinaries index:

RBA Cash Rate compared to the dividend yield for stocks in the All Ordinaries index

Data Source: AFR Smart Investor

As you can see, between 2000 and mid-2008, the RBA Cash Rate was higher than the All Ords dividend yield. In fact the Cash Rate was an average of 1.79 percentage points above the All Ords’ yield.

That relationship flipped as the financial system collapsed and the RBA cut interest rates to a record low. Things appeared to revert to normal during 2010, but that didn’t last long.

Since 2009, the average spread between the Cash Rate and dividend yields is now -0.64 percentage points. In other words, dividend yields are now higher than the Cash Rate.

So, what does that mean? Well, it’s the key to investing over the next two years…

Why This ‘Flip’ is Great News for Growth Stocks

To be honest, we can’t see that relationship flipping back anytime soon. The RBA will have to keep interest rates low in order to try to stimulate the Australian economy (not that we agree the RBA should do this, we’re simply saying this is what they’ll probably do).

That will force normally conservative investors to buy dividend-paying stocks.

We’re reluctant to use the word, but it could create a temporary ‘floor’ for Aussie stocks as long as the central bank keeps rates low. Note the emphasis on ‘temporary’.

Interest rates look set to stay low for the time being. That’s typically good news for stocks. All that remains to know is whether companies can maintain or grow earnings and dividends.

As we said at the top, that’s all that really matters in the stock market – interest rates and earnings.

That said, we also believe that dividend stocks have already boomed.

We don’t think you’ll see further big gains. If dividend stocks do go up, it’s more likely to be low single-figure gains, even if as Doc Cowie expects, you see a new credit boom due to low interest rates and China’s infrastructure spending.

In short, if the days are over for income and growth from dividend stocks, it’s only natural that speculators will look for big gains elsewhere. That should mean a good year ahead for growth stocks, especially small-cap growth stocks.

If the last six months was all about yield, our bet is the next year will be all about growth.

Cheers,
Kris

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Kris Sayce
Kris is never one to pull punches when discussing market developments and economic events that can affect your wealth. He’ll take anyone to task — banks, governments, big business — if he thinks they’re trying to pull a fast one with your money. Kris is also the investment director for Australian Small-Cap Investigator, Diggers and Drillers and Revolutionary Tech Investor. If you’d like to more about Kris’ financial world view and investing philosophy then join him on Google+. It's where he shares investment insight, commentary and ideas that he can't always fit into his regular Money Morning essays. Read more about Publisher and Investment Director Kris Sayce.

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