The last few weeks have been painful. People have broken both their hearts and lost their wallets. I tried to do a soul searching of why the PE of so many stocks was falling. I would not say that prices were falling because we have all said that so many times yet they continue to fall and fall and fall – as if there is no tomorrow. A dear friends calls me up each time the market is down by more then 200 pts and says – India kya khatam ho gaya kya? I have no clear answers. Sometimes we blame the LME metal prices sometimes the crude factor, sometimes, Bombay blasts, sometimes the DMK threat. Come one there has to be one cause for one effect. The bottom-line is nobody knows what will happen. Yet we never miss an opportunity to provide our piece of advice. Markets may fall a bit and then stay in a range to consolidate before rising by October, November… Now if some body can prove these theories he would qualify for a noble prize!! I am sure he would they would not even sit down to discuss they will just decide and the winner can walk away with all that wealth.

Text books claim that when interest rates go up the market PE declines. That is the market PE =(1/interest rates) but why does this happen. I tried to look for some answers.

Ø       Buffet always suggested that investors should do a Discounted Cash Flow of stocks. That is the company’s free cash flow in the nest 5 or 7 years be discounted at some inflation adjusted rate called the cost of capital. If the discounting factor goes up (rising interest rates increase the cost of capital) then the final answer has to be lower. Hence lower stock prices or lower PE’s take it the way you like.

Ø       Also companies that are engaged in expansionary activities and employ a lot of debt show lower profits (as the interest costs go up) leading to lower E.P.S and lower stock prices.

In the aforesaid event Investors would do well to focus on investment into sectors that remain unaffected by interest rates like consumer pharmaceutical, media etc. On the other hand investors should do away from investing into sectors like Capital goods (raising capacities will be costlier), Banking, cyclical..

Before I ring the death knell let me the interest rate cycle may let me share with you some past data. During the previous interest rate up cycle in 1994 – 2000 we had some stocks that did extraordinarily well. Take a look at the names like  Infosys, Wipro, Satyam, HDFC Bank, Dr. Reddy’s so if an investor holding an assorted portfolio of these stocks would have sold in 1994 since he apprehended rising interest rates I am not sure if he would have recovered from the shock.

In the present scenario the markets are very volatile.We have observed in the past few weeks the market changes are unpredictable and there is a situation of rising interest rates.In the past few weeks the NAV`s of the mutual funds have shed around 40%, stock prices have also fallen and looks attractive now.We know that stocks generally outperform in the long term.so to avoid this market volatility one should take long positions in the stocks that are reasonable or should be investing in mutual funds.Volatility in the stock markets is a natural phenomenon. More often than not, markets remain volatile over the shorter term and in the long term they generally go up. There are strategies to turn volatility to one's advantage. One such strategy is to invest systematically over a period of time. By following a disciplined approach, one invests at different level of markets instead of timing the market. This in a way ensures that the average cost is lower than the average NAV and that ensures the growth over the longer term.

Intresting Analysis of the Intrest Rates structure......