The Dow Jones Industrial Average, S&P 500 index, and NASDAQ have all hit historic highs since the election of Donald Trump to the presidency of the United States. Stock markets tend to reflect the anxieties and aspirations of the populace, and given the general economic stability in the US, investors have been piling into the markets with increasing alacrity. A slight cooling of expectations has taken place, but equities remain the go-to option for many private and institutional investors. At the time of writing, the Dow Jones Industrial Average was hovering around the 25,300 mark, the S&P 500 index around 2,830, and the NASDAQ composite index at 7,830.
These levels were not on anybody’s radar at the height of the global financial crisis and its aftermath. Quantitative easing enacted during the Obama administration allowed the financial markets to get a grip and ultimately paved the way for the boom that followed. Now that quantitative tightening is taking place, with rising interest rates, multiple sectors of the US economy are set to benefit. Foremost among them are banking and financial stocks. The correlation between interest rates and bank stocks is ironclad. As interest rates rise, so the yield on borrowed money increases. Banks are in the business of lending money at high rates of interest. As such, the trifecta of deregulation for banks (a relaxation of Dodd Frank regulations), rising interest rates, and lower corporate taxes ensures that banks will be long-term viable prospects for investors.
As a case in point, several leading financial exchange traded funds (ETFs) have made their way to market, including the ETF Industry Exposure & Fin SVCS, the iShares US Brokerage Dealers & Security Exchange, the Innovator IBD 50 ETF, and Fidelity MSCI Financials Index ETF among others. Among the bank stocks, yields have been relatively strong for the big 3 US banks including Bank of America (BAC), Goldman Sachs (GS), and Wells Fargo (WFC). BAC stock has virtually tripled in value since the start of 2016, and these are justified gains, given the bank’s strong fundamentals. Investments in BAC have tempered in 2018, in line with the general performance of global bourses.
Consider that deposits at Bank of America since 2016 have grown substantially, leaving competitors in their wake. Of course, the greatest catalyst for bank stock performance is the interest rate. At the time of writing, the CME Group FedWatch tool indicates that the Federal Funds Rate (the interest rate at which banks borrow) is hovering around 1.75% – 2.00% with strong upside potential to rise in the region of 2.00% – 2.25% at the next meeting of the Fed on September 26, 2018. There is plenty of speculative sentiment about how rising interest rates will impact investments in equities. On the one hand, there is clear consensus that higher interest rates are beneficial to ownership of banking and financial equities. The linear correlation makes sense. At the same time, the general performance of many stocks has been rather lackluster. Problems with Turkey’s currency, sanctions on Russia, the Iranian economic collapse and other issues are weighing heavily on stock markets.
Getting the Money to Invest in Equities
New and experienced investors seeking to cash in on the performance of bank stocks moving forward (given that multiple rate hikes are anticipated in coming months) will do well to evaluate their options vis-à-vis borrowing money to invest in equities. Warren Buffett cautioned against too much leverage, but careful and methodical investing where risk and reward are evaluated can certainly pay dividends. It’s a matter of borrowing from Peter to pay Paul and collecting a premium after all is said and done. The trick to investing with borrowed money is understanding how interest rates work.
Hypothetical Example Using BAC Stock
For example, if BAC stock is expected to rise approximately 10% by the end of the year (September – December) and it is currently priced at $31.90 per share, we can expect a share price of around $35 by Christmas time. If the interest rate on a loan is expected to be 6% per year, that works out to 0.06/12 = 0.5% per month. If you bought $100,000 of BAC shares at an interest rate of 0.5% for 6 months, you would be paying $500 per month in interest for 4 months equals $2,000 in interest. If the yield on BAC is 10% over 4 months, that works out to 2.5% per month on $100,000, or $2,500 per month. Subtract $500 from that and you get an overall yield of $2000 in profit, barring trade fees, account brokerage fees, commissions etc. Of course, there is no guarantee that BAC stock will rise by 10% by Christmas, but if it does, you can certainly cover the costs of your short-term loan and generate a healthy return in the process.
You may think that borrowing from a bank to invest in a bank stock is a little strange, and you would be correct. Banks would not simply advance money for investment in bank stocks, and if they did, they would require significant paperwork on your part. There are many other options available to you, including non-bank entities such as online quick loans which can be used to invest with as you please. As a business, you could diversify your portfolio by investing in foreign markets, through international holding companies. Typical small business loans providers include companies like Get Capital, Capify and Prospa. These entities can fast-track loans for companies and provide funding in the region of $5000 – $400,000 + depending on your businesses track record.
Businesses can diversify their holdings and include an equity portfolio as part of their range of available assets. This acts as a hedge against downturns, and can certainly outpace interest rate growth on loans, with appreciation on equities. Nowadays, there is increasing interest in investments in alternative online lending platforms in the UK, with increased buyer sentiment in payday lenders, marketplace lending, and specialty finance. Investing in lenders is also a viable proposition, given the boom in non-bank lending that is currently taking place in the financial markets.