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Buy On Margin When Rates Are High

May 20, 2012 11:17 PM ET
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rsawyer's Blog
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Investors should buy equities on margin when interest rates are high. Sound crazy? Hear me out:

What typically happens when interest rates are too high? All it means is that there is not enough money to lend for the amount of money demanded; so, the only way to decrease interest rates is to either increase money supply or decrease money demand. What you find is that companies begin losing money, because money demand decreases and hence demand for their products. Earnings are released, investors start pulling their money out of equities, and the market tanks. You would think the best play here is to buy bonds, after all, interest rates are high, right? Not so.

There are two ways to win at investing: be first or be smart. We will use both of these. Taking a smart and logical approach here, typically:

High interest rates => Money pulled out of equities => Equity prices undervalued

"That sounds well and good," you say. "But what about the interest rates being high (our cost of capital)? How do we know that the assets are undervalued enough to overcome the high interest rates?"

Well, I'll tell you: margin interest rates are variable; lines of credit are variable. It's genius, really. In order for people to invest (and borrow money), interest rates will have to come down. This is usually helped by the Fed who will print more money, which reduces interest rates even more. What you will find is that you purchased equities near the bottom, the interest rate decreased as equities rose, and your cost of capital diminished as your capital skyrocketed. Soon enough, your Debt/Equity ratio is de minimus as the value of your Assets Under Management increase, and the higher interest rates in the next business cycle have an immaterial effect on your profitability.

Such a contrarian approach is likely to yield the investor excess returns as he takes on more and less risk at the most opportune times.

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