What is the best way to react to the Fed’s policy tightening measures? This is a question that should be on the mind of every investor as bond yields are continuing to climb.
Ben Bernanke at the Joint Economic Committee
Ben Bernanke basically caused a market sell-off in the bond market. As the world’s most powerful banker stated that he would be willing to raise the federal funds target rate once the unemployment rate were to hit 6.5%. The problem is that the unemployment rate is currently 7.5%, and a full 1% decline in unemployment could happen within the next year and a half. But it may take less time than that.
In response to a rising interest rate environment, bond investors have sold their bonds aggressively onto the bond market. This should be a point of concern to investors as declining bond values will hurt every investor’s portfolio.
Source: Ycharts
The value of the iShares Barclays TIPS Bond Fund (ETF) (NYSEARCA:TIP) has declined by 3.87%. This hurts fixed income investors as rising interest rates means that the value of a bond note will decline in response. Investors are now investing aggressively into stocks.
Source: Ycharts
The SPDR S&P 500 (NYSEMKT: SPY) gained 13% since the beginning of the year. These gains are likely to continue in an environment where bond values are declining and stock values are increasing. After all, if you had the choice between making money and losing money, chances are you will choose the option that would help you to make the most money.
Legal power of banks
The Financial Accounting Standards Board has made some changes in 2009 that allow for mark-to-market accounting practices. This means that a company will have to record paper gains or losses without actually realizing them. So if a bank had a position in a stock, and the value of the stock declined, the company would have to report that decline in value as a loss immediately (even though the bank hasn’t sold the stock yet).
This has huge implications in the bond market. If the value of a bond decreases, the decrease in the value of the bond would be fully reflected in the bank’s financial performance when it reports earnings. Larger banks, as a result, have been buying stocks; this will result in an increase in the amount of earnings a bank can report to shareholders.
Because of mark-to-market accounting and deflationary monetary policy, it is highly likely that this strong upwards trend in the value of stocks and bond interest rates will continue. It is wise for an income oriented investor to buy stocks with high dividend yields.
Banks have played their cards right
Goldman Sachs Group, Inc. (NYSE:GS) has invested aggressively into stocks in anticipation of rising stock values and declining bond values. Goldman Sachs reported a 24% growth in revenues from its equity securities trading. The company also saw equity underwriting revenue grow by 69%. The company’s business is favorably impacted by the stock market.
So it’s highly likely that the numbers of publicly listed stocks are going to increase by a drastic amount. After all, when is a better time to buy into stock than in a bull-market?
Morgan Stanley (NYSE:MS) reported 30% growth in institutional securities trading in its latest quarter. After all, everyone makes money in a bull market. Morgan Stanley (NYSE:MS) has been buying a lot of stocks, which is why its stock continues to appreciate. Morgan Stanley grew its asset management revenues by 21% (investors are flocking into the stock market which helps to boost Morgan Stanley’s fee income from asset management).
I am a huge fan of investing into these banks. It is likely that both companies will benefit heavily from this favorable stock market environment. The decreasing value of bonds will mean even further increases in equity values. Performance based asset management fees will be going up even further, which is why an investment into both Morgan Stanley (NYSE:MS) and Goldman Sachs Group, Inc. (NYSE:GS)will mean substantial returns on investment.
Conclusion
Banks are positioning themselves intelligently. The decreasing value of bonds and increasing value of stock securities are heavily favorable to our Wall Street banks. That being the case, investors should look to divest out of fixed income and buy into stocks.
Alexander Cho has no position in any stocks mentioned. The Motley Fool recommends Goldman Sachs.
The article How To Win in an Environment of Rising Interest Rates originally appeared on Fool.com.
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