by Archie M. Richards, Jr., CFP^®
July 28, 2003

If you guide your investments by short-term economic news - even vital news - you'll lose money and possibly go bonkers.

One example of vital, short-term economic news is changes in long-term interest rates - borrowings of ten years or longer.

Let's say you're a business owner. You want to build a production facility that costs $10 million. You borrow $10 million for ten years.

The interest rate on ten-year business debt is 4 percent. Each year, you'll pay your creditors $400,000 interest (4 percent of $10 million). No matter what happens to rates during the ten years, your payments remain the same. At the end of ten years, you repay the $10 million. Over the entire period, your interest payments total $4 million.

Alternatively, assume that at the time you borrow the $10 million, the interest rate on ten-year business debt is 5.4 percent instead of 4 percent. Your interest payments are $540,000 a year - $5.4 million over ten years.

With your payments larger by $1.4 million ($5.4 million less $4 million), your $10 million production facility must generate considerably more money just to cover the extra borrowing costs. If it can't, the facility you hoped would add to your wealth might end up draining it.

Remember, it's the interest rate prevailing on the day you borrow that determines your cost for the entire ten years. The level of long-term interest rates is vitally important for the economy's long-term future.

How might increases in long-term interest rates affect short-term moves in the stock market? Let's see. Around June 15, 2003, the interest rate on ten-year Treasuries was 3.1 percent. (When people talk about interest rates in general terms, they usually refer to the rates on money borrowed by the federal government. These rates are lower than those of any other kind of debt. The rates paid by everyone else scale higher.)

Okay, as I say, back in the middle of June, Treasuries maturing in ten years were trading at prices that gave them yields of 3.1 percent. The Dow Jones Industrial Average was 9000.

Six weeks later, at the time of this writing at the end of July, 2003, ten-year Treasuries are trading at prices that give them yields of 4.2 percent.

From 3.1 to 4.2 percent in only 6 weeks! Businesses borrowing ten-year money must pay more interest than they would if they'd borrowed only six weeks earlier. The production facilities they build with the borrowed money must generate considerably more just to cover the additional costs. Such a big rise in long-term rates is a significant burden on the economy.

In the middle of June, if you'd somehow learned what interest rates would do in the ensuing six weeks, you'd have sold your stocks, wouldn't you?

If you had, you'd have been dead wrong. During the six weeks, stock prices did not fall. The Dow rose almost 300 points.

What? A vital ingredient of the economy turned sour, yet stock prices rose? How can this be?

I don't know. But I do know this: The stock market is always weird. If you try to anticipate its short-term changes, you'll lose money and go nuts.

It's tempting to assume that stock prices reacts to economic and business news as we expect. We like to spot relationships. Something like 85 percent of the activities of our brains are devoted to recognizing patterns. It's easy to assume that the stock market reacts as our intuitions expect.

It doesn't. The stock market is counter-intuitive. Many of the relationships cited on television business shows regarding the stock market have no predictive value and are unhelpful.

When you stay invested for many years, the wealth generated by the people of the world causes stock prices to rise. But predicting prices based on short-term economic and business news is perilous. You'll lose your money and turn daffy. As a general rule, just buy and hold.