Question: Are higher interest rates bad for stock prices ?
The conventional wisdom says yes, but the opposite case can be made as well. As a famous lawyer once said, “I can argue it both ways”.
As an economy, the US is one the cusp of exiting its worst deflationary period since the Great Depression. In the post WW II period, the three great wealth creation vehicles were
A.) small business creation;
B.) common stocks (via long-term investing) and;
C.) real estate, both residential and commercial;
Starting with March, 2000 and the bursting of the technologty and the large-cap growth bubbles, and then spectacularly with the 2008 recession, two of those three wealth vehicles came crashing to earth.
Today, with the SP 500 making new all-time highs, and residential real estate in a bona fide recovery, the average American with a home and a 401(k) is starting to feel like risk-taking, hard work, savings and investment actually might pay off.
The constant cacophony around interest rates is puzzling and deafening. This is just a personal opinion, but given the PCE (Personal Consumption Expenditure) data, and the spread between the yield on the 10-year Treasury TIPS, and the 10-year Treasury, the “true” inflation rate is probably around 1.5%. (The Treasury TIPS curve now looks to be inverted with the 10-Year TIPS yielding a a negative 60 basis points. I’m not sure what that is telling us other than inflation continues to “deflate” or disinflation continues.)
Given that the historical “real return of return” on Treasuries is 2% over the period dating back to the 1970’s, the 10-year Treasury yield SHOULD eventually trade between 3.5% – 4%.
Stock prices will adjust to these higher yields, with the stock market impact depending on the speed of the “mean reversion” to 3.5% – 4%.
If we get to 3% by Labor Day, the SP 500 will likely be down hard. If the Treasury vigilantes adjust Treasury yields at a measured and slower pace in advance of the Fed, the SP 500 should continue to make new highs.
While everybody is now talking “1994” in terms of the historical pattern, a more frightening period was early in 1987. Remember, the pro-growth policies of the Reagan Adminstration, and the falling interest rates from the 15% high in 1980, not to mention the collapse in crude oil to per barrel in 1986 to $10 per barrel, drove a huge boost in economic growth in during the 1984 – 1986 period. However, in early 1987, crude oil started to rise, and the dollar started to weaken measurably, resulting in a horrid rise in Treasury yields throughout 1987.
From January to early October, 1987 the 30-year Treasury yield rose from 7% to close to 10%. The 10-year Treasury yield rose from 7% to over 9% over the same time period.
Between March and May, 1987 alone, the 30 year Treasury yield rose from the low 7% to 8.5%, accouting for the majority of the move. (For those old enough to remember, Merrill Lynch supposedly lost an obscene amount of money in March, 1987, as one of their mortgage traders threw a ticket in a drawer and forgot about it. The amount i remember is $300 ml, but I cant verify that. I think the trader is still around too.)
We all know what happened in October, 1987, too. Interest rates rose for a long time before the equity markets corrected, and the SP 500 tripled from 120 to 380 between August, 1982 and early October, 1987.
Still, the US economy today is more similar to 1990 – 1993, than the mid-1980’s. Fiscal policy is a huge drag on the monetary stimulus.
High interest rates are on their way: faster economic growth would be a huge positive, as would even a bit of inflation. However too much of both (at too fast a rate) isn’t a good thing.
Dont obsess about interest rates, but do obsess about the rate of that change: that is the key.
I had lunch with Jeff Miller of A Dash of Insight a week ago. For those worried about “Fed tapering” or easing up on QE, Jeff told me that the Fed’s QE program accounts for about 1% of Treasury volume per day. He has a good update this weekend in the attached link.
The 10-year Treasury broke above the early March, 2013 high of 2.09%. The next technical level is 2.39% – 2.40% from Spring, 2012.
At our lunch, Jeff Miller and I talked about the negativity around the US equity markets and the current valuation of the SP 500. Jeff thinks the “earnings yield” currently at 6.95% is an equity risk premium (ERP) proxy, and that with a 5% ERP, the SP 500 should trade at 20(x) forward estimates, or at least feels that is reasonable math. Jeff is a PhD in economics from the University of Michigan. I learn from him with every conversation.
My own facile and simplistic view is that we are well below “peak p.e” ratio’s in terms of former stock market tops, 15(x), versus high 20(x)’s in 1987, March, 2000.
What I fund puzzling is all the earnings data being banded about in all the blogs. Some bloggers use trailing earnings, some use forward earnings estimates (as I do, from ThomsonReuters), some use reported earnings, some use operating (as ThomsonReuters does) and some use bottoms-up (quarterly) versus top-down, i.e. annual estimates. John Butters, now at FactSet is a former ThomsonReuters guy. He is very bright and writes the weekly FactSet report, simialr to what I get from ThomsonReuters, “This Week in Earnings”. I have to reconcile these two sources at some point.
One friend from Twitter pinged me and asked what I had for the SP 500 earnings for 2012: my reply was $103.80. This person was using $92 per share for SP 500 earnings for 2012 ! (Contrary to others opinions, I think the quality of today’s earnings are far higher today, certainly than the late 1990’s, since most large-cap tech companies are shrinking their share base (despite stock option grants) with most of the attribution due to far higher cash-generation, which is going to share repurchases. Some think that is a negative, which I dont understand. Shrinking your outstanding common shares benefits your investor base, since it is accretive to earnings per share.)
Per ThomsonReuter’s “This Week in Earnings”, the forward 4-quarter estimate for SP 500 earnings fell to $113.38, down from $113.43 last week. The “earnings pattern” remains pretty normal in terms of how we typically trek through the quarter.
We remain just shy of the record forward estimate of $115.25 on April 5th, 2013, and are seeing less erosion in the forward estimate.
The p.e on the forward esimate is now 14.38.
The “earnings yield” is 6.95%.
The year-over-year growth in the forward estimate is now growing again at 4.20%. Before showing you the data, I want to give it a few more weeks to make sure the trend sticks.
Nothing unusual to conclude: Q2 SP 500 earnings growth was 5% on flat revenue growth. I still think we will see a 10% growth quarter or SP 500 earnings in either Q3 ’13 or Q4 ’13, and SP 500 earnings are NOT a reason to be worried about the stock market.
Not one company we follow reports this week. Pretty quiet for SP 500 earnings. 490 of the SP 500 have reported Q1 ’13 already.
With some of this stronger-than-expecetd economic data, I wonder if we don’t start hearing some positive “earnings pre-announcements”. Could happen, (just like it could happen that I start dating a super-model – want to see who has read this far).
May employment report for June 7th is expecting roughly 165,000 – 175,000 net jobs created by the US economy in May ’13. Last month, with the revisions, was VERY strong. Is the Treasury market telling us job growth is accelerating ?
We sold all of our homebuilding stocks this week. Here is why. Would like to buy them back at some point. (Long small position in TOL and LEN in long-term account – sold the majority.)
Intel looks good as we wrote earlier this week. The Barron’s article this weekend thinks similarly. (Long INTC)
Norm Conley (@Jag_Norm) , at JA Glynn is St. Louis, with 30-year Treasury and 10-Year Treasury charts. Everyone now watching the Spring, 2012, 10-year Treasury high yield of 2.39% – 2.40%. (Norm is a long-term friend from our days together on the www.thestreet.com and a good investor. Follow him on Twitter. His insights are worth it…)
Gary Morrow, another long-time friend from the Street.com, tweeted this week on CME’s chart. We have been pounding the table on CME, here and way back here from August, 2012. Eurodollar volume saw a huge jump this week, per Morrow. The Treasury complex at the CME has a 99% market share. (We are long CME and some ICE as well.)
Jeffrey Kleintop (@jeffreykleintop) strategist at LPL Financial, tweeted on May 28th that while everyone obsesses about the 600 days without a 10% decline in the SP 500, we have gone 1,670 (!) days without a 5% correction in the Barclay’s Aggregate (AGG). Wow, that is one amazing statistic. How painful will this be when the 30-year duration rally ends ?
Tesla (TSLA) seems to be at the forefront of the electric car, given that the Tesla doenst look like an air conditioner on wheels. Never owned the stock, but I wonder what a widespread adoption of the hybrid and the electric car does to gasoline consumption. There seem to be three factors inhibiting electric car adoption: 1.) Price (even with gas savings, the price of an electric car or a hybrid makes the switch a breakeven proposition at best today), 2.) Battery technology (which will improve), and 3.) Range limitation, i.e. the need to recharge for trips over 100 miles, not to mention the lack of available recharge facilities. (No TSLA, but long a bunch of Ford (F).)
I think we get there one day in terms of widespread adoption by consumers of the electric car or hybrid. The day will come.
Remarkably boring stuff, but here is why TIPS might have inverted yields as we discuss above. From the Cleveland Fed, a piece on current inflation. The inflationista’s have been wrong for years. Think about what would happen if gasoline falls dramatically as the hybrid or electric car gains traction ?
Facebook (FB) looks good here. Bought more Friday. One of the few truly oversold stocks we can find, outside of telco and utilities. Here is our blog update on FB, that came out prior to the recent upgrades of Facebook from SPCapital IQ and another firm. Pay attention to the revisions in revenue estimates. (Long FB)
The high-yield ETF’s look interesting: the HYG and JNK had a tough week, down 2%.
Portfolio strategy: we manage all individual clients money via separate accounts at Charles Schwab (SCHW), which is a stock we are long. We thought we’d add a section to feature our longer and short-term strategies for client portfolios:
Overweight equities: prefer US large-cap given the valuation, which gives clients international exposuire as well. Overweight equities given the standard 60% / 40% asset allocation.
Underweight duration: like everybody else, I think interest rates have nowhere to go but up.
Don’t own any gold, and think the dollar will strengthen gradually for a while, at least the next few years.
Equity: overweight technology and financials. Slowly positioning portfolios for a “return to global growth” scenario, which includes industrials / cyclicals.
Fixed-income: the TBF (unlevered inverse Treasury ETF) is now one of our largest positions, given the 10-year yield traded above 2.09%. We are overweight credit risk too, given the slowly improving US economy. The high-yield ETF’s had a tough week, this past week, down 2%. We think high-yield still works in terms of a tactical allocation. May add to high yield this coming week.
Summary: the SP 500 is still about 2% above its 50-day moving average and is only in the earliest stages of being “oversold”. SP 500 earnings are actually fine, and face easier comp’s as we move through 2013. Bullish stock market sentiment per Bespoke plunged this week, despite a pretty modest correction in the markets, which tells you volumes about how current individual investors are viewing the current equity market rally.
A pullback in the SP 500 to 1,600 or the October ’07 high of 1,575 would be perfect.
Thanks for reading and stopping by:
Trinity Asset Management, Inc. by:
Brian Gilmartin, CFA