Rising Interest Rates- Good Or Bad For Stocks?

Of all the bear cases I have heard from investors, the one that seems to gain the most traction is the concern about what happens to the market when the Fed tapers their bond purchases and eventually begin to raise interest rates.  Many believe the Fed has been propping up the stock market with low rates and once that begins to fade, the market will soon follow.  While we would agree that what the Fed has done is unprecedented, we have argued before that rising interest rates may not be bad for stocks.  Blackrock is out with a research piece that confirms our own prior research that stocks can hedge a rising rate environment:

rates stocks

 

So why is that?  Interest rates tend to rise during times of economic growth, so while the cost of borrowing may be rising, revenue growth should be occurring at the same time.  In addition, rising rates often correspond with rising inflation.  Again, companies have the ability to pass through higher costs by increasing the prices of their own products.  The other important item to note is the performance of bonds during these periods. While rising rates haven’t been devastating to bonds, you can see that their performance hovers around break-even.  So, for those that are concerned about rising rates, please make sure you review this chart and understand that while this time may be different, rising rates have historically not been catastrophic for stocks.

Safe Is The New Risky

If you were to ask most investors what is the least risky investment you can purchase you probably wouldn’t be surprised to hear treasury bonds and gold as their answer.  Treasury bonds are literally considered risk free assets as they are backed by the full faith and credit of the United States.  Gold has historically been known as a great “store of value”.  The thought goes that countries can devalue their currencies but gold will always hold its value through periods of extreme inflation or deflation.

So let’s say going into 2013 you were worried about the upcoming year.  You’d probably have quite a few reasons to feel that way.  Although it was a long time ago, you probably remember the “fiscal cliff” fiasco, strained government negotiations, higher tax rates, sequester spending cuts, and the upcoming rollout of Obamacare.  In anticipation of these events you might have decided that this was a time to get “safer” with your portfolio, allocating a healthy dose of  gold and treasury bonds to your portfolio mix.  Let’s take a look at how you would have fared.

Treasury Bonds (as measured by the TLT ETF) is down around 12% this year.  Gold is down 25% for the year.  The point of this post is not meant to say these investments should not be in your portfolio (well, maybe not gold), but that trying to outsmart the market by re-positioning portfolios based on what direction you think the market is going is a dangerous game.   The other lesson we have learned is that even perceived safe investments can lose money.

Predicting Performance

Predicting the stock market in advance is one of the hardest things to do (and have yet to find someone who can do it consistently).  It doesn’t mean we shouldn’t understand what drives long-term performance, which is why we are going to devote this post to the factors that impact returns and what would be a reasonable assumption for future performance.  To begin with, there are three factors to consider when looking at investment returns:  dividends, earnings, and valuation.  We’ll look at each one separate:

Dividends:  this is the amount of cash a corporation pays out to its shareholders each year.  We often look at this as a percentage of the stock price, otherwise known as the dividend yield.  Today, that yield on the S&P 500 is 2%, so we’ll assume the next year stays pretty constant at that rate.

Earnings:  This is the amount of profits a company makes after it pays all it’s expenses.  According to a survey of all the analysts that cover the S&P 500 companies, earnings are supposed to grow at 14% over the next 12 months.  One thing we know is that analysts have been overly optimistic recently, so let’s assume this persists and earnings growth comes in at 10%.

Valuation:  This is the big wildcard, as valuation is the price that investors are willing to pay for a stream of earnings.  It can vary wildly.  In the 1990s as greed and optimism were running rampant, people were willing to pay record high prices for stocks.  In the ensuing decade, as many investors shunned stocks, the price they were willing to shell out for those earnings dropped significantly.  Today, we are very close to historical averages, so let’s assume that valuation does not add or detract from returns.

The formula to determine returns is as follows:  Dividend Yield + Earnings Growth +/- Valuation change = Stock Market Performance

When we substitute our assumptions for each of these variables, we find that returns come in at 12% over the next year.  Now, you have to take that with a grain of salt since no one knows what the future will bring.  A recession could cause a collapse in earnings, continued political gridlock could cause investors to change the valuation of the market, dividends paid from companies could grow or shrink depending on things like the economic environment or changes to the tax laws, interest rates could dramatically alter valuations and earnings growth.  

Understanding the different dimensions of market returns is a great way to deconstruct the past, but it is usually not a great way to forecast the future.

What If Things Went Right…

Everyone is acutely aware of the risks that lay in front of us.  With two devastating bear markets, many investors are just waiting for the next shoe to drop.  Just for a moment, I wanted to bring your attention to an alternative scenario.  What if things went right?  What if all of the things we are worrying about today, just don’t materialize like we think they will?  This isn’t just wishful thinking.  History is filled with examples of innovation overcoming seemingly insurmountable obstacles.  The automobile solved the issue of manure from horses infecting our cities.  New technologies for finding oil solved the peak oil crisis we were supposed to hit 20 years ago. 

So, I’ve listed the major obstacles we face today, and I’ve taken the liberty to think about what could go right:

  • Government debt- conventional wisdom shows that our government debt is going to continue to climb to astronomical levels, eventually causing massive inflation.  The reality is the debt has been shrinking with growing tax revenue and cost controls.  With small changes to Social Security (raise retirement age, means testing, etc) and healthcare innovation (see below) to drive down costs, we could eventually see a surplus.
  • Healthcare- one of the main drivers of government debt has been healthcare.  The US spends more than any other country on healthcare per citizen, by almost double.  Medicare is the leading cause of future deficits, so this is both a healthcare and budget issue.  Technology will most likely be the answer to this problem.  As I write this, there is tremendous advances being made in the biotechnology and healthcare technology.  Where do most healthcare costs come from in the US come from?  Testing.  The US performs twice as many tests on patients than other countries.  Nanotechnology and smart phones applications are being developed to perform these tests at a fraction of the cost.  Technologies that will diagnose and prescribe medicine for you without seeing a doctor are also being developed.  The point is that the costs associated with healthcare today could be drastically different in the future due to new technology.
  • Natural Resources- there is a finite supply of natural resources in this world and eventually we will run out.  This has been discussed for decades.  In 1974 Jimmy Carter said we could use up all of the proven reserves of oil within the next decade.  Why haven’t we run out?  New technology has found millions of barrels of oil over the last several decades that could never be extracted before.  In addition, natural gas, solar, wind and nuclear technology have come on line and it is hard to even predict where this will even take us in the next few decades.
  • Education- the cost to educate a child is becoming absurd and the market for college loans is finally showing signs of cracking.  Universities are now offering free online courses.  I just took an MBA level course from the University of Virginia for free.  Other sites like Khan Academy lets anyone watch online courses about nearly anything.  Becoming educated will no longer require a $50,000 per year price tag.  While no one knows how the educational system will change, there is a good chance that college will look a whole lot different in 20 years.

Innovation is not only the key to solving our problems, but will also be the key to growth over the coming decades ahead.  When you bet against the economy and the market, you are betting against human ingenuity, which has almost always been a losing proposition.  I am excited to see where that ingenuity takes us.

 

 

 

Real Yields Are Back!

For the past several years, investors putting their money into bonds have been getting yields less than the rate of inflation.  This means that your money is not keeping pace with purchasing power.  With the spike in yields over the past couple months, that trend is reversing.  Investors are now getting some return over inflation as shown by the chart of the 10 year Treasury TIP yield:

FRED Graph

So what does this mean for investors?  We believe that bonds (at least longer term bonds) are now worth revisiting.  That does not mean that investors should be loading up on 30 year bonds in their portfolios, as yields are still near record lows.  But, for those investors who avoided bonds at all costs over the past few years, this may be a time to dip a toe in the water.  While real yields are still low, there is finally some compensation for the risk you are taking.  We are still using bonds with fairly short maturities, but we are encouraged by this sign for fixed income investors.

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.