Posts filed under ‘Themes – Trends’

Santa and the Rate-Hike Boogeyman

Slide1

Boo! … Rates are about to go up. Or are they? We’re in the fourth decade of a declining interest rate environment (see Don’t be a Fool), but every time the Federal Reserve Chairman speaks or monetary policies are discussed, investors nervously look over their shoulder or under their bed for the “Rate Hike Boogeyman.” While this nail-biting mentality has resulted in lost sleep for many, this mindset has also unfortunately led to a horrible forecasting batting average for economists. Santa and many equity investors have ignored the rate noise and have been singing Ho Ho Ho as stock prices hover near record highs.

A recent Deutsche Bank report describes the prognostication challenges here:

i.)  For the last 10 years, professional forecasters have consistently been wrong on their predictions of rising interest rates.

Source: Deutsche Bank

Source: Deutsche Bank via Vox

ii.)  For the last five years, investors haven’t fared any better. As you can see, they too have been continually wrong about their expectations for rising interest rates.

Source: Deutsche Bank via Vox

Source: Deutsche Bank via Vox

I’m the first to admit that rates have remained “lower for longer” than I guessed, but unlike many, I do not pretend to predict the exact timing of future rate increases. I strongly believe inevitable interest rate rises are not a matter of “if” but rather “when”. However, trying to forecast the timing of a rate increase can be a fool’s errand. Japan is a great case in point. If you take a look at the country’s interest rates on their long-term 10-year government bonds (see chart below), the yields have also been declining over the last quarter century. While the yield on the 10-Year U.S. Treasury Note is near all-time historic lows at 2.18%, that rate pales in comparison to the current 10-Year Japanese Bond which is yielding a minuscule 0.36%. While here in the states our long-term rates only briefly pierced below the 2% threshold, as you can see, Japanese rates have remained below 2% for a jaw-dropping duration of about 15 years.

Source: TradingEconomics.com

Source: TradingEconomics.com

There are plenty of reasons to explain the differences in the economic situation of the U.S. and Japan (see Japan Lost Decades), but despite the loose monetary policies of global central banks, history has proven that interest rates and inflation can remain stubbornly low for longer than expected.

The current pundit thinking has Federal Reserve Chairwoman Yellen leading the brigade towards a rate hike during mid-calendar 2015. Even if the forecasters finally get the interest rate right for once, the end-outcome is not going to be catastrophic for equity markets. One need look no further than 1994 when Federal Reserve Chairman Greenspan increased the benchmark federal funds rate by a hefty +2.5%. (see 1994 Bond Repeat?). Rather than widespread financial carnage in the equity markets, the S&P 500 finished roughly flat in 1994 and resumed the decade-long bull market run in the following year.

Currently 15 of the 17 Fed policy makers see 2015 median short-term rates settling at 1.125% from the current level of 0-0.25%. This hardly qualifies as interest rate Armageddon. With a highly transparent and dovish Janet Yellen at the helm, I feel perfectly comfortable the markets can digest the inevitable Fed rate hikes. Will (could) there be volatility around changes in Fed monetary policy during 2015? Certainly – no different than we experienced during the “taper tantrum” response to Chairman Ben Bernanke’s rate rise threats in 2013 (see Fed Fatigue).

As 2014 comes to an end, Santa has wrapped investor portfolios with a generous bow of returns in the fifth year of this historic bull market. Not everyone, however, has been on Santa’s “nice” list. Regrettably, many sideliners have received no presents because they incorrectly assessed the elimination impact of Quantitative Easing (QE). If you prefer presents over a lump of coal in your stocking, it will be in your best interest to ignore the Rate Hike Boogeyman and jump on Santa’s sleigh.

Investment Questions Border

 

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own a range of positions, including certain exchange traded fund positions, but at the time of publishing SCM had no direct position in DB or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

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December 20, 2014 at 12:24 pm Leave a comment

Where are the Economists’ Yachts?

Yachts istock II

“Where Are the Customers’ Yachts?” was a book first published about 75 years ago in 1940 by Fred Schwed, Jr. Before he became an author, Schwed was a professional trader who eventually left Wall Street after losing a significant amount of money during the 1929 stock market crash. The title of Schwed’s book refers to a story about a visitor to New York who admired the yachts of the bankers and brokers. Naively, the visitor asked where all the customers’ yachts were? Of course, none of the customers could afford yachts, even though they obediently followed the advice of their bankers and brokers.

The same principle applies to economists. The broad investing public, including many professionals, blindly hang on to every economist’s word. And why not? Often these renowned economists are quite articulate – they use big words, crafty jargon, and wear fancy clothes. Unfortunately in many (most) cases the predictions are way off base. What’s more, if these economists/strategists/analysts/etc. were so clairvoyant, then how come we do not find any of them on the Forbes 400 list or see them captaining massive yachts?

Recently, the Washington Post highlighted the spotty forecasting track record of the Federal Reserve, as it related to past projections of economic growth. As you can see from the chart below, the Board of Governors were consistently too optimistic about future economic growth prospects.

Source: Washington Post

Source: Washington Post

The Federal Reserve has repeatedly proved it is no slouch when it comes to poor forecasting. The example I often point to is the infamous 1996 “irrational exuberance” speech (see also NASDAQ 5,000 Déjà Vu?) given by then Federal Reserve Chairman Alan Greenspan. In the talk, Greenspan warned of escalated asset values and cautioned about a potential decade-long malaise similar to the one experienced by Japan. At the time, the NASDAQ index stood at 1,300, but despite Greenspan screaming about an overvalued market, three years later, the tech-laden index almost quadrupled in value to 5,132.

There are plenty more errant economist forecasts to reference, but despite the economists’ poor batting averages, there is virtually no accountability of the pathetic predictions by the media outlets. Month after month, and year after year, I see the same buffoons on cable TV making the same faulty predictions with zero culpability.

While I have attempted to keep some of the economists/strategists honest (see The Fed Ate My Homework), credit must be given where credit is due. Barry Ritholtz, the lead Editor of The Big Picture, last year wrote a smart piece on the accountability (or lack therof) in the prediction industry.

In the article Ritholtz described some of the shenanigans going on in the loosely regulated prediction industry. Here’s part of what he had to say:

Pundits are highly incentivized to adhere to the following playbook:

  1. make a brash prediction
  2. if wrong, don’t worry…. no one will remember
  3. if right, selectively tout for self-promotion
  4. repeat cycle

Ritholtz also describes another time-tested strategy I love…The 40% Rule:

“The 40% rule is the perfect way to make a splashy headline and cover your butt at the same time. Forecast that there’s a 40% chance that the Dow Jones Industrial Average clears 12,000 by year end: If it does, you’ll look like a sage, and if it doesn’t, well, you didn’t say it’s the most likely outcome.”

 

Whatever your views are of predictions made by high profile economists and pundits, the media archives are littered with faulty forecasts. It is difficult to dispute that the projection game is a very tough business, and if you don’t share the same opinion, please explain to me…where are the all the economists’ yachts?

Click Here for Other Bad Predictions

Investment Questions Border

 

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own a range of positions in certain exchange traded fund positions, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

December 6, 2014 at 11:21 am 2 comments

Fiscal Armageddon Greatly Exaggerated

Source: Photobucket

Source: Photobucket

“The reports of my death are greatly exaggerated.”

-Mark Twain (after a relative’s illness was attributed to Twain)

The same can be said for the exaggerated death of the U.S. economy and stock market. Naysayers have been pounding a consistent stream of fatal economic theories for years as a positive set of broader metrics disassembled those arguments. Debt downgrades, debt defaults, and a domino of European country collapses were supposed to set our financial markets spiraling downwards out of control. That didn’t happen.

A large contributing component to our oversized debt burden was the massive federal, state, and local deficits. Consider the federal fiscal deficit that reached -$1.5 trillion during the 2008-09 Financial Crisis.

Many of the doom-and-gloomer pundits expected a deficit in the uber-trillion dollar range to last for as far as the eye could see, but perception didn’t turn out to be reality. Scott Grannis at Calafia Beach Pundit always does a superb job of summarizing this government related data (see chart below):

Source: Calafia Beach Pundit

Source: Calafia Beach Pundit

All too often people confuse a secular trend vs. a cyclical move. The collapse in tax revenues during the 2008-2009 timeframe was not the result of some permanent shift in tax policy, but rather a function of a cyclical downturn, much like we have seen in prior recessions.

Extrapolating a short-term trend into a long-term trend is a common investor mistake (see Extrapolation Dangers). While the mean reversion in tax revenues came as a surprise to some, it was no bombshell for me. When the country axes 9 million private jobs and then both companies and consumers rein in spending due to depression fears, a subsequent reduction in tax receipts should not be a shock to market observers. On the flip side, it should then be no revelation that tax revenues will rise when 9 million+ jobs return and confidence rebounds.

We have talked about the shape of tax revenues/receipts, but what about the shape of spending? With all the gridlock occurring in Washington, Americans are fed up with the government’s inability to get anything done, which is evident by the near-record low approval rating of Congress. But as I have written before, not all the effects of gridlock are bad (see Who Said Gridlock is Bad?). What Grannis’s chart above shows is that gridlock has beneficially resulted in about five years of flat spending. Despite the spending stinginess, the slow and steady economic recovery has continued virtually unabated since 2009.

Looked at from a slightly different lens, you can see the deficit reached its worst point in 2009 at about -$1.5 trillion (-10% of GDP) – see chart below. Today, the deficit has almost been cut by 2/3rds to a level of -$0.5 billion (-2.8% of GDP). As you can see, the current deficit/GDP percentage is consistent with the average deficit levels experienced over the last 50 years.

Source: Calafia Beach Pundit

Source: Calafia Beach Pundit

Regardless of your political persuasion, investors are best served by not placing too much focus on what’s going on in Washington D.C. Equal blame and credit can be dispersed across Congress (Democrats & Republicans), the President, and the Federal Reserve. Exaggerating the death of the U.S. economy and stock market may sell more newspapers and advertising, but the resilience of capitalism and innovative spirit of American entrepreneurship has not and will not die.

Investment Questions Border

 

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own a range of positions in certain exchange traded fund positions, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

November 15, 2014 at 10:48 pm 1 comment

The Gift that Keeps on Giving

Christmas Present Wrapped in Gold and Silver

There have been numerous factors contributing to this bull market, even in the face of a slew of daunting and exhausting headlines. Contributing to the advance has been a steady stream of rising earnings; a flood of price buoying stock buybacks; and the all-important gift of growing dividends that keep on giving. Bonds have benefited to a lesser extent than stocks over the last five years in part because bonds lack the gift of rising dividend payouts. Life would be grander for bondholders, if the issuers had the heart to share generous news like this:

“Good day Mr. & Mrs. Jones. As your bond issuer, we value our mutually beneficial relationship so much that we would like to reward you as a bond investor. In addition to the 2.5% we are paying you now, we have decided to increase your annual payments by 6% per year for the next 20 years. In other words, we will increase your $2,500 in annual interest payments to over $8,000 per year. But wait…there’s more! You are such great people, we are going to increase the value of your initial $100,000 investment to $450,000.”

 

Does this sound too good to be true? Well, it’s not…sort of. However, the scenario is absolutely true, if you invested $100,000 in S&P 500 stocks during 1993 and held that investment until today. Unfortunately, the gift giving conversation above would be unattainable and the furthest from the truth, if you invested $100,000 into bonds. Today, if you decided to invest $100,000 in 20-year government bonds paying 2.5%, your $2,500 in annual payments will never increase over the next two decades. What’s more, by 2034 your initial principal of $100,000 won’t increase by a penny, while inflation slowly but surely crushes your investment’s purchasing power.

To illustrate the magical power of dividend compounding at a 6% CAGR, here is a chart of the S&P 500 dividend stream over the 21-year period of 1993 – 2014:

SP500 Dividends 1993-2014

The trend of increasing dividends doesn’t appear to be slowing either. Here is a table showing the number of S&P 500 companies increasing their dividend payouts:

COUNT OF DIVIDEND ACTIONS YEAR-TO-DATE INCREASING THEIR DIVIDEND
2014 YTD 292
2013 366
2012 333
2011 320
2010 243
2009 151

Source: Standard and Poor’s

As I mentioned before, while dividends have more than tripled over the last twenty years, stock prices have gone up even more – appreciating about 4.5x’s (see chart below):

SP500 1993-2014 Chart

With aging demographics increasing retirement income needs, it comes as no surprise to me that the percentage of S&P 500 companies paying dividends has increased from 71% (351 companies) in 2001 to 84% (423 companies) at the end of Q3 – 2014. Interestingly, all 30 members of the Dow Jones Industrial Average currently pay a dividend. If you broaden out the perspective to all S&P Dow Jones Indices, you will discover the strength of dividends is particularly evident over the last 12 months. During this period, dividends increased by a whopping +27%, or $55 billion.

This trend in increasing dividends can also be seen through the lens of the dividend payout ratio. It is true that over longer timeframes the dividend payout ratio has been coming down (see Dividend Floodgates Widen) because of share buyback tax efficiency. Nevertheless, more recently the dividend payout ratio has drifted upwards to a range of about 32% of profits since 2011 (see chart below):

Source: FactSet

Source: FactSet

There’s no disputing the benefit of rising stock dividends. Baby Boomers, retirees, and other long-term investors are increasingly reaping the rewards of these dividend gifts that keep on giving.

Other Investing Caffeine articles on dividends:

Dividends: From Sapling to Abundant Fruit Tree

Dividend Floodgates Widen

Investment Questions Border

 

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in  certain exchange traded funds (ETFs) including SPY, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

October 25, 2014 at 10:05 am 1 comment

Scrapes on the Sidewalk

Scraped Knees

Baron Rothschild, an 18th century British nobleman and member of the Rothschild banking family, is credited with the investment advice to “buy when there’s blood in the streets.” Well, with the Russell 2000 correcting about -14% and the S&P 500 -8% from their 2014 highs, you may not be witnessing drenched, bloody streets, but you could say there has been some “scrapes on the sidewalk.”

Although the Volatility Index (VIX – a.k.a., “Fear Gauge”) reached the highest level since 2011 last week (31.06), the S&P 500 index still hasn’t hit the proverbial “correction” level yet. Even with some blood being shed, the clock is still running since the last -10% correction experienced during the summer of 2011 when the Arab Spring sprung and fears of a Greek exit from the EU was blanketing the airwaves. If investors follow the effective 5-year investment playbook, this recent market dip, like previous ones, should be purchased. Following this “buy-the-dip” mentality since the lows experienced in 2011 would have resulted in stock advancing about +75% in three years.

If you have a more pessimistic view of the equity markets and you think Ebola and European economic weakness will lead to a U.S. recession, then history would indicate investors have suffered about 50% of the pain. Your ordinary, garden-variety recession has historically resulted in about a -20% hit to stock prices. However, if you’re in the camp that we’re headed into another debilitating “Great Recession” as we experienced in 2008-2009, then you should brace for more pain and grab some syringes of Novocaine.

If you’re seriously considering some of these downside scenarios, wouldn’t it make sense to analyze objective data to bolster evidence of an impending recession? If the U.S. truly was on the verge of recession, wouldn’t the following dynamics likely be in place?

  • Two quarters of consecutive, negative GDP (Gross Domestic Property) data
  • Inverted yield curve
  • Rising unemployment and mass layoff announcements
  • Declining corporate profits
  • Hawkish Federal Reserve

The reality of the situation is the U.S. economy continues to expand; the yield curve remains relatively steep and positive; unemployment declined to 5.9% in the most recent month; corporate profits are at record levels and continue to grow; and the Fed has communicated no urgency to raise short-term interest rates in the near future. While the current headlines may not be so rosy, and the Ebola, eurozone, and Chinese markets may be giving you heartburn, nevertheless, the stock market has steadily climbed a wall of market worry over the last five years.

As the great Peter Lynch stated (see also Inside the Brain of an Investing Genius), “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” Stated differently, Value investor Seth Klarman noted, “We can predict 10 of the next two recessions,” which highlights pundits’ inabilities of accurately predicting the next downturn (see also 100-Year Flood ≠ 100-Day Flood). As Lynch also adds, rather than trying to time the market, it is better to “assume the market is going nowhere and invest accordingly.”

Now may not be the time to dive into stocks headfirst, but many stocks have fallen -10%, -20%, and -30%, so it behooves long-term investors to take advantage of the correction. It’s true that buying when there is “blood in the streets” is an optimal strategy, but facts show this is a difficult strategy to execute. Rather than get greedy, long-term investors may be better served by opportunistically buying when there are “scrapes on the sidewalk.”

Investment Questions Border

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in  certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

October 18, 2014 at 8:50 pm Leave a comment

The Pain of Diversification

Pressure

The oft-quoted tenet that diversification should be the cornerstone of any investment strategy has come under assault in the third quarter. As you can see from the chart below, investors could run, but they couldn’t hide. The Large Cap Growth category was the major exception, thanks in large part to Apple Inc.’s (AAPL) +8% appreciation. More specifically, seven out of the nine Russell Investments style boxes were in negative territory for the three month period. The benefits of diversification look even worse, if you consider other large asset classes and sectors such as the Gold/Gold Miners were down about -14% (GDX/GLD); Energy -9% (XLE); Europe-EAFE -6% (EFA); Utilities -5% (XLU); and Emerging Markets -4% (EEM).

*Results are for Q3 – 2014 (Source: Vanguard Group, Inc. & Russell Investments)

*Results are for Q3 – 2014 (Source: Vanguard Group, Inc. & Russell Investments)

On the surface, everything looks peachy keen with all three major indices posting positive Q3 appreciation of +1.3% for the Dow, +0.6% for S&P 500, and +1.9% for the NASDAQ. It’s true that over the long-run diversification acts like shock absorbers for economic potholes and speed bumps, but in the short-run, all investors can hit a stretch of rough road in which shock absorbers may seem like they are missing. Over the long-run, you can’t live without diversification shocks because your financial car will eventually breakdown and the ride will become unbearable.

What has caused all this underlying underperformance over the last month and a half? The headlines and concerns change daily, but the -5% to -6% pullback in the market has catapulted the Volatility Index (VIX or “Fear Gauge”) by +85%. The surge can be attributed to any or all of the following: a slowing Chinese economy, stagnant eurozone, ISIS in Iraq, bombings in Syria, end of Quantitative Easing (QE), impending interest rate hikes, mid-term elections, Hong Kong protests, proposed tax inversion changes, security hacks, rising U.S. dollar, PIMCO’s Bill Gross departure, and a half dozen other concerns.

In general, pullbacks and corrections are healthy because shares get transferred out of weak hands into stronger hands. However, one risk associated with these 100 day floods (see also 100-Year Flood ≠ 100-Day Flood) is that a chain reaction of perceptions can eventually become reality. Or in other words, due to the ever-changing laundry list of concerns, confidence in the recovery can get shaken, which in turn impacts CEO’s confidence in spending, and ultimately trickles down to employees, consumers, and the broader economy. In that same vein, George Soros, the legendary arbitrageur and hedge fund manager, has famously written about his law of reflexivity (see also Reflexivity Tail Wags Dog). Reflexivity is based on the premise that financial markets continually trend towards disequilibrium, which is evidenced by repeated boom and bust cycles.

While, at Sidoxia, we’re still finding more equity opportunities amidst these volatile markets, what this environment shows us is conventional wisdom is rarely correct. Going into this year, the consensus view regarding interest rates was the economy is improving, and the tapering of QE would cause interest rates to go significantly higher. Instead, the yield on the 10-Year Treasury Note has gone down significantly from 3.0% to 2.3%. The performance contrast can be especially seen with small cap stocks being down-10% for the year and the overall Bond Market (BND) is up +3.1% (and closer to +5% if you include interest payments). Despite interest rates fluctuating near generational lows with paltry yields, the power of diversification has proved its value.

While there are multiple dynamics transpiring around the financial markets, the losses across most equity categories and asset classes during Q3 have been bloody. Nonetheless, investing across the broad bond market and certain large cap stock segments is evidence that diversification is a valuable time-tested principle. Times like these highlight the necessity of diversification gain to offset the current equity pain.

Investment Questions Border

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in AAPL, BND, and certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in EEM, GDX, GLD, EFA, XLE, XLU, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

October 11, 2014 at 8:55 am Leave a comment

Mathematics 101: The Cheap Money Printing Machine

Woman Using Atm Machine

Like many other bloggers and pundits, I have amply pontificated on the relative attractiveness of the stock market. For years, cash and gold hoarding bears have clung to the distorted, money-losing Shiller CAPE P/E ratio (see CAPE Smells Like B.S.), which has incorrectly signaled investors to stay out of stocks and miss trillions of dollars in price appreciation. Apparently, the ironclad Shiller CAPE device has been temporarily neutralized by the Federal Reserve’s artificially cheapening money printing press policies, just like Superman’s strength being stripped by the nullifying powers of kryptonite. The money printing logic seems so elegantly sound, I felt compelled to encapsulate this powerful relationship in an equation:

Interests Rate Cuts + Printing Press On = Stocks Go Higher

Wow, amazing…this is arithmetic any investor (or 3rd grader) could appreciate! Fortunately for me, I have a child in elementary school, so I became emboldened to share my new found silver bullet equation. I initially received a few raised eyebrows from my child when I introduced the phrase “Quantitative Easing” but it didn’t take long before she realized Rate Cuts + QE = Fat Piggy Bank.

After the intensive tutorial, I felt so very proud. With a smile on my face, I gave myself a big pat on the back, until I heard my child say, “Daddy, after looking at this squiggly S&P 500 line from 2007-2014, can you help my brain understand because I have some questions.”

Here is the subsequent conversation:

Me: “Sure kiddo, go ahead shoot…what can I answer for you?”

Child: “Daddy, if the Federal Reserve is so powerful and you should “not fight the Fed,” how come stock prices went down by -58% from 2007 – 2009, even though the Fed cut rates from 5.25% to 0%?”

Me: “Uhhhh….”

Child: “Daddy, if stock prices went down so much after massive rate cuts, does that mean stock prices will go up when the Fed increases rates?”

Me: “Uhhhh….”

Child: “Daddy, if Quantitative Easing is good for stock prices, how come after the QE1 announcement in November 2008, stock prices continued to go down -25%?”

Me: “Uhhhh….”

Child: “Daddy, if QE makes stocks go up, how come stock prices are at all-time record highs after the Fed has cut QE by -$70 billion per month and is completely stopping QE by 100% next month?”

Me: “Uhhhh….”

Child: “Daddy, everyone is scared of rate increases but when the Fed increased interest rates by 250 basis points in 1994, didn’t stock prices stay flat for the year?”

Me: “Uhhhh….” (See also 1994 Bond Repeat)

What started as a confident conversation about my bullet-proof mathematical equation ended up with me sweating bullets.

Math 101A: Low Interest Rates = Higher Asset Prices

As my previous conversation highlights, the relationship between rate cuts and monetary policy may not be as clear cut as skeptics would like you to believe. Although I enjoy the widely covered Shiller CAPE discussions on market valuations, somehow the media outlets fail to make the all-important connection between interest rates and P/E ratios.

One way of framing the situation is by asking a simple question:

Would you rather have $100 today or $110 a year from now?

The short answer is…”it depends.” All else equal, the level of interest rates will ultimately determine your decision. If interest rates are offering 20%, a rational person would select the $100 today, invest the money at 20%, and then have $120 a year from now. On the other hand, if interest rates were 0.5%, a rational person would instead select the option of receiving $110 a year from now because collecting a $100 today and investing at 0.5% would only produce $100.50 a year from now.

The same time-value-of-money principle applies to any asset, whether you are referring to gold, cars, houses, private businesses, stocks, or other assets. The mathematical fact is, all else equal, a rational person will always pay more for an asset when interest rates are low, and pay less when interest rates are high. As the 200-year interest chart below shows, current long-term interest rates are near all-time lows.

Source: The Big Picture

Source: The Big Picture

The peak in interest rates during the early 1980s correlated with a single digit P/E ratio (~8x). The current P/E ratio is deservedly higher (~16x), but it is dramatically lower than the 30x+ P/E ratio realized in the 2000 year timeframe. If none of this discussion makes sense, consider the simple Rule of 20 (see also The Rule of 20 Can Make You Plenty), which states as a simple rule-of-thumb, the average market P/E ratio should be equal to 20 minus the level inflation. With inflation currently averaging about 2%, the Rule of 20 implies an equilibrium of ~18x. If you assume this P/E multiple and factor in a 7-8% earnings growth rate, you could legitimately argue for 20% appreciation in the market to S&P 2,400 over a 12-month period. It’s true, a spike in interest rates, combined with a deceleration in earnings would justify a contraction in stock prices, but even under this scenario, current index values are nowhere near the bubble levels of 2000.

After six long years, the QE train is finally grinding to a halt, and a return towards Fed policy normalcy could be rapidly approaching. Many investors and skeptical bears have tried to rationalize the tripling in the market from early 2009 as solely due to the cheap Fed money printing machine. Unfortunately, history and mathematics don’t support that assertion. If you don’t believe me, perhaps a child may be able to explain it to you better.

Investment Questions Border

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own a range of positions in certain exchange traded fund positions, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

September 27, 2014 at 4:19 pm 2 comments

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