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Why rising interest rates can be better for your portfolio

Over the last couple of weeks, the markets have been in retreat and the headlines have turned decidedly negative (the latter due to the former). Investors are nervous about what is going to happen next.

My response? Don't let the recent mayhem put you off track. For those with broadly diversified portfolios, things haven't been so bad and the past week could actually be a healthy sign.

Yes, the Canadian stock market, which is dominated by companies in the resource and interest-sensitive sectors such as energy, mining, banks and REITs, has had some rough days, but the S&P/TSX Composite Index is down only 2.5 per cent this year once you factor in dividends. The U.S. market, as measured by the S&P 500, is up 13 per cent. Most balanced funds are in positive territory for the year.

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Last week's flare-up was prompted by news that the largest economy in the world is improving. The Federal Reserve signalled that U.S. growth is sustainable and there's less need for artificial stimulation. What could be better than that? It's growth without Viagra. We knew there would be a jolt when the economy picked up and the Fed took its foot off the gas. Presumably, some of that necessary jolt is now behind us.

Rising interest rates are a healthy sign because previously rates had been unsustainably low. The recent rate rise puts the economy and capital markets on a better footing, although yields are still below where valuation measures suggest they should be. Borrowers may be in Mae West's camp – "Too much of a good thing can be wonderful" – but for the markets' long-term health, near-zero is too much. Low rates and a seemingly unlimited availability of credit have distorted asset prices and resulted in increased risk taking.

Before last week, borrowers and lenders had slid into an unhealthy complacency around interest rates ("I know they're too low, but there's no way they're going up any time soon"). They now have a fresh appreciation that ultra-low bond yields and mortgage rates aren't normal.

Over all, the last few weeks have been healthy because the stock market needed a "pause that refreshes." It had come a long way and investors were looking for a pullback before they committed new money. If the current weakness gets chronically underinvested people into the market, it will have been a good thing.

I don't know if this bond market correction and stock market pause will stay healthy, or turn into an overreaction. In this regard, Mr. Market is predictably unpredictable and is known for overreacting to short-term news.

So where do I go at times like this? Rather than try to outfox the mercurial market, I retreat to a quiet place with a cup of tea (or glass of wine) and look at the fundamentals, valuations and market sentiment.

The economic fundamentals and outlook for corporate profits haven't changed. The recovery in the developed world is still tenuous (or non-existent) and growth in the developing world is slowing. The U.S. is a positive part of that mix with its improving housing market, more competitive manufacturing sector and declining unemployment.

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Valuations in fixed-income securities have improved. As for stocks, I was already of the view that valuations were in a normal range. With interest rates between 2 per cent and 3 per cent, price-to-earnings multiples in the mid-to-high teens looked just fine. But with stock prices going up faster than profits over the last year, multiples had moved to the upper end of that range. The recent price declines are bringing them back toward the middle.

Market sentiment, which acts as a contrarian indicator, isn't giving me a definitive signal at this point, but last week's market action was interesting. The fact that stocks, bonds and gold all went down tells me that some speculators are getting shaken out, which is a good thing for long-term, valuation-driven investors.

Capital markets are in need of a better balance. The sooner they get there and complacency abates, the better off investors will be. If it means some short-term bumps along the way, it's worth it.

Tom Bradley is president of Steadyhand Investment Funds Inc.

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About the Author
Tom Bradley

Tom Bradley is the President and founder of Steadyhand Investment Funds. His education includes a Bachelor of Commerce degree from the University of Manitoba (1979) and an MBA from the Richard Ivey School of Business (1983).Tom started his investment career in 1983 as an Equity Analyst at Richardson Greenshields. More

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