Long title, but very important subject. It is common knowledge that low interest rates are bullish for stocks...right? Wrong, or at least not always. Sure it seems pretty elementary that if US Treasuries yield 1.6%, and high grade corporate bonds yield 2%, than a stock yielding 3% or 4% seems pretty attractive. Well, this is certainly the reason almost every pundit on CNBC (especially those selling dividend paying equity funds) is touting buying dividend paying stocks. This logic assumes that investors simply look at relative yields and buy the most attractive, without asking why. The problem with this logic is the simple fact that it fails to question why Treasuries yield 1.6%.
The why is more important than the relative yields. Treasuries are low for two main reasons; 1) the Fed and their Central Bank colleagues have manipulated rates as low as possible to try and stimulate some semblance of economic growth, and fight off the deflation monster, and 2) investors are fearful and have therefore run to the perceived protection of Treasuries, Bunds, and JGB's. It's just plan silly to hear some people talk of Treasury Bonds as being in some sort of bubble. Bubbles are all about greed. No one is running to Treasuries (and their negative real returns) thinking they're going to get rich. People buy Treasuries here out of fear, not greed.
The thing that the Fed and the western worlds Central Banks fear most is not inflation, but deflation. Inflation is the monster lurking in the basement. Deflation is the monster under the bed, breathing on the back of your neck. Deflation is the immediate threat, and it is why the central banks are doing all they can to reflate their economies. You see, our central bankers are fully aware that in a world where the G10 has $70 trillion in debt that is collateral for $700 trillion in derivatives, deflation is the immediate risk, not inflation. In an inflationary world those enormous debts are paid off with cheaper and cheaper currencies. Inflation is the friend of the debtor. Consider a home purchaser. They purchase a $300,000 home with 20% down, borrowing 80%, they owe $240,000. In an inflationary world the value of their home appreciates over the life of the loan, making the debt as a percent of the equity value decline. In a deflationary world the value of the home declines, making the debt as a percent of the equity value surge. This is the environment we live in today, many homeowners underwater, owing more than the home is worth.
You've probably heard the term, "Pushing on a string". The Fed's efforts to stimulate the economy via massive injections of liquidity have been like "pushing on a string," in other words, not very successful.
The chart below shows the velocity of money. Wikipedia defines the velocity of money as "the average frequency with which a unit of money is spent on new goods and services produced domestically in a specific period of time. Velocity has to do with the amount of economic activity associated with a given money supply."
As you can see the velocity of money has collapsed. In fact it has been in a rather steady decline since the mid-90's, and is now at record lows. The demand for money is simply dwarfed by the supply of money.
The best sign that the deflationary monster is being beaten back is wage increases. Inflation in wages is a sign of a healthy, expanding economy. Unfortunately wages have been in a long-term secular decline for decades. The median wage level in the US today is about $50,000, if it had just kept pace with inflation it should be about $90,000.
The suppression of wages has come from both a rise in productivity and a large labor pool. This decline in real wages contributes to the lack of aggregate demand, and feeds the deflationary monster.
Why aren't low rates positive for stocks?
Let's take another peak at the Velocity of Money chart above. If you look at the period coming out of the 1982 recession the velocity of money went from about 1.7x to 2.1x in 1997. Interest rates fell throughout that period from about 11% to 4.5%, and stocks had their best decade on record. The S&P 500 actually returned 19.2% annually in the ten year period ending in 1998. As rates continued to fall from 1998 to 2008 from 4.5% to 2.5% the S&P 500 actually turned its worst ten year annualized return with a negative 1.3%.
The moral: Low rates don't automatically equal higher stock prices. The key is, why are rates low.
Lets look at the Japanese experience, another country with ballooning deficits.
Japanese interest rates have been below 2% since the late '90's, and Japanese stocks yield more that Japanese Government Bonds, so stocks are attractive versus bonds...right? Wrong. Since 1998 when Japanese yields broke below 2%, Japanese stocks have fallen from about 15,000 to their current level of about 8,600, a decline of 43%.
Summary:
A low rate environment does not automatically mean stocks are attractive. Sometimes low rates are indicative of an economy that is struggling to grow, and may even be fighting back the deflationary monster. Stock returns are simply a reflection of a country's ability to grow its economy. Corporate profit margins may be near record levels, and dividend yields may exceed bond yields, but if the fear of deflation is in the air P/E's will contract. These are tough times to make money investing. Stay defensive, diversified, and most importantly vigilant and flexible.
High-Yield Portfolio:
After my May 24th Supermodel Revisited post I've received several inquiries regarding our High-Yield portfolio. Attached is a pdf that goes into some more detail regarding this product. If you would like to talk in more detail about how this portfolio may help you achieve your income goals please give me a call.
Be careful out there, and keep the lights on,
Chris Wiles, CFA
412-260-7917
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This article contains the current opinions of the author but not necessarily those of the Rockhaven Capital Management. The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
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