Question

Explain how movements in the stock markets can affect the economy and the business cycle. Also explain why in periods of uncertainty investors prefer to buy bonds and avoid the equity market? Elaborate your answer by appropriate data and charts to get full credit. Cite the sources of data and charts. Your response should be 1- 2 pages, single spaced, and not more than 12 point font. (20 points)

Answer 1

The stock market tends to be a leading indicator of the business cycle, since investors look to other indicators and tend to exit the market at or before an economic contraction and return to the market during recovery.

Sources of the Business Cycle's Impact

Investor Expectations: Essentially, investors move money based on where they see future profit (or loss) potential. Such movements can then affect the overall market itself, since more dollars entering the market tends to drive stock prices higher.

Inflation expectations are another source of business cycle impact on the stock market.

If it is assumed that inflation will rise in the near future (see the sections below), interest rates tend to rise, and this has a negative impact on stock (and bond) prices.

Ironically, people look to stocks as an inflation hedge, but stocks actually do poorly during periods of high inflation.

Of course, over long periods of time, the return on stocks does beat the general rate of inflation.

Bond v/s equity in uncertainty -

Talk to any fund manager today and he will give multiple reasons for investing in equities to gain from a possible bull run. Low valuations, improving economy and tapering of liquidity injection by the US central bank are some positives they think will propel equity markets to a high.

But there are those who say it's too early to get carried away by this euphoria. Inflation, they say, is a big worry. The turning off of the US liquidity tap may have been delayed but is inevitable.

For investors, making sense of this is tough. The thumb rule in such a situation is to diversify based on goals and investment horizon.

Long-term investments can safely be put in equities. However, for periods less than two-three years, it's best to be safe and go for fixed income options. The latter, due to various factors that are keeping interest rates high, have turned especially attractive of late.

While bank fixed deposits, or FDs, and post office schemes are some of the safest options, investors can also look at earning more than what is paid by bank FDs and Public Provident Fund (PPF). Some such options are debt mutual funds, nonconvertible debentures (NCDs) of companies, tax-free bonds by infrastructure companies and inflation-indexed bonds. The latter two have long maturities.

Before any decision, investors must assess where we are and where we are headed
An increase in interest rates impacts bond prices. If investors are earning more from bank deposits than in the bond market, bond prices fall, as investors sell them and park money in banks. Thus, the value of their bond investments falls. Of course, if they hold the bonds till maturity, they will earn regular income (called coupon) and get the principal at maturity.

However, if they have to sell before maturity, there are chances they will make losses. For new investors, it is an opportunity to buy at a lower price and earn a higher yield. If they hold till maturity, they can gain both from capital appreciation as well as interest earned. However, due to the uncertainty about interest rates, it's a question of which side the camel sits.

In spite of the uncertainty over interest rates, current bond yields and bank FD rates are still attractive and are offering decent returns with lower risk.

Banks are offering 9-10% on one-three year FDs. Corporate FDs and NCDs with high credit rating are also offering this much or slightly more. Then there are tax-free bonds (many available in the market currently) offering up to 8.7-8.9% for maturities up to 20 years. The interest earned on these bonds is not taxed.

Those who want to gain from high-yield bonds should invest in debt funds as they cannot buy bonds directly due to the large ticket size involved. Debt/bond fund investment can be as low as Rs 5,000. Since mutual funds are managed by professionals, it is better to leave your money in their hands, as they are usually wellqualified to take informed investment bets.

However, you still have to choose the funds. You can go for buy-and-hold (passive) funds such as fixed maturity plans, or FMPs, which have lock-in periods. The fund manager buys high-yield bonds and holds them till maturity. Else, you can adopt an active strategy by investing in funds that look to gain from coupon payments as well as capital appreciation by predicting interest rate movements and timing buy/sell decisions.

Investors can also adopt duration strategy. Usually, longer duration bonds trade at higher yields but are riskier than securities with shorter durations, which have lower yields.

Whatever strategy you adopt, it should be based on your risktaking ability and time horizon.

"Strategies focused on corporate and short-term bonds can help investors navigate the current uncertain environment. Investors who have a longer horizon and are comfortable with interim volatility can build longdated portfolios,"

Asset allocation approaches require that a part of the portfolio remains in fixed income securities as they provide a cushion against equity market volatility. Since returns from these move in opposite direction to that from equity markets, they are an ideal diversification tool for your portfolio.

However, for retail investors , bank and company FDs and post office savings are the most popular products in this category.

A smarter way to build one's debt portfolio is to also look for bond funds as they offer opportunities to benefit from changes in the interest rate cycle and gain not just from interest income but also from capital appreciation.