The correction long overdue ..

Ten year treasury yield surged beyond 5% and reached 5.14% today. Stock market reacted to this in a predictable way, by surrendering more than 1.5% of its gains today alone. In the past three sessions, the Dow index has given up more than 410 points, S&P 500 fell below 1500 and, the important point is that this drop was accompanied by higher volume. Sounds like there is some more correction on the way.

Interest rate sensitive stocks lead the way today. That included Bank stocks, Mortgage lenders, Home builders, REIT (Real Estate Investment Trusts), Utilities companies. The witness was in the following Spider ETFs: XHB (home builders) by 3%, XLF (financial) by 1.7%, XLU (Utilities) by 3%. However, this sell off was broad based as S&P 500 was down by 1.7% as well.

At the same time this correction was widely expected since our markets were roaring with no end in sight (like they always do before correction!). I was expecting this correction in the past three weeks, but I was not sure where would the trigger be coming from. But then some events happened around the world that changed the perception in the bond markets to reflect this new yield rate.

One of the compelling influences is from global rise in interest rates. New Zealand raised interest rate by 25 basis points today. 10 year yield rates in Japan and Germany rose to their highest levels since December 2002. Expectations for additional interest rate hikes by the Europe Central Bank and the Bank of England also increased. Global growth has been very strong, employment all around the world has been growing and so the yields had to rise.

The playing field has moved on to a higher level; the borrowing cost has increased. Stock markets will have to adjust to the new interest rate. And this can affect everyone, particularly the smaller companies that are sensitive to borrowed money. Small cap companies have provided higher returns than larger cap companies all these days. But this new interest rate can make a difference now in transferring the balance back in favor large cap companies or funds.

Another activity that had picked up a lot of steam these days was the Private Equity take-over. Private companies were taking advantage of low interest rates to buy other companies. This take over spree had shrunk the total stock market, there by shrinking the supply of stocks. The rising interest rates will discourage any more private equity take over. This bullish factor may loose its strength in the future.

I had been waiting for this correction for a while now; I need to decide on which sectors are well poised to take advantage of this correction. However for this correction, I will generally be looking for Large Cap companies and large cap funds, since I think that large cap performance has been lagging for a long time now and can capitalize better on the current economic situation.

-Nidhi