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The U.S. and global market selloff that began in late January was preceded by a rapid rise in U.S. treasury bond yields. Rates on 10-year U.S. Treasuries reached 2.95% on January 21; as of this writing they are again hovering near 3%.
The U.S. and world markets are understandably nervous about the pattern of higher interest rates — for the simple reason that bonds compete with stocks for capital.
In the language of mathematics, the economy is a “non-linear dynamic system.” In human language, that just means that the functioning of an economy has many, many elements that interact to produce the economy’s behavior. It also means that the change of one or a few elements may have large effects that are very difficult to model or predict. Since the economy as it exists and functions in the real world is chaotic and resistant to being thoroughly modelled and understood, economists have usually succeeded only in building models that explain a few aspects of the economy’s past behavior… and in terms of predicting the future, these models have been of little help. Those with a practical interest in the effects of an economy’s behavior — such as investors — need to examine the models, but also supplement them with real-world experience.
In this letter, we will discuss a few of the most important factors currently at work in the U.S. and global economy, and examine the effect that these can have on stock and bond markets — and on investment returns. We’ll also include some real-world reflection based on our experience of navigating these markets as investors for much of the past half-century.
Stocks, Bonds, and Interest Rates
We noted above that stocks and bonds compete for capital. This means simply that as people decide how to invest their money, on a large scale, they are comparing the returns that they anticipate from the instruments in which they could invest. So there is a constant “beauty contest” going on, particularly between two of the most liquid (easily bought and sold) asset classes — stocks and bonds. Generally, stocks are perceived to be riskier than bonds (although under some circumstances, bonds can be much riskier than many believe). It is also well-documented that over the long term, stocks provide a return substantially higher than that of bonds.
The competitive advantage in the “beauty contest” has been greatly in favor of stocks since the U.S., European, Japanese and other central banks pushed interest rates down to unprecedented levels to stimulate economic growth after the Great Recession of 2008–09. With interest rates so low, stocks offered a superior total return including both dividends and price appreciation.
Now, with interest rates gradually normalizing and with the world economy growing, bonds are once again able to compete with stocks for returns. Income seeking investors can buy short-term corporate bonds paying 3% and income stocks paying 4–5%.
Interest Rates Bottom and Begin To Rise — Fast
The decline in interest rates ended in July 2016 at absurdly low levels — about 1.3% for a 10-year U.S. Treasury bond. (We say that such levels are “absurd” both because they were historically anomalous, and because such numbers would imply an unreasonably dismal view of the future of the U.S. economy.) From there, interest rates rose until early 2017, and then retraced to form a higher bottom at 2% in September, 2017. The move upward in U.S. interest rates from September 2017 till today is unexceptional — just 1% in absolute terms if looked at from a long-term perspective.
However, looked at from a short-term trading perspective, it is a 50% increase in 8 months. In terms of both magnitude and speed, that’s a big move. The rapidity of this move, as well as the prospect for further interest rate increases (most likely two or three more this year), has shrunk the price-to-earnings ratio (P/E) of stocks.
Still, we repeat what we have been saying since 2017: historically, the market continues to move up after the yield curve first significantly narrows.(Remember that the yield curve is the difference between long-term and short-term interest rates. When short-term interest rates rise above long-term, credit ultimately shuts down, and a recession and a bear market ensue.)
Interest Rates, P/E Multiples, and Dividends
The price-to-earnings ratio expresses how much investors are willing to pay for a share of a company’s future earnings. From company to company, it varies according to a huge range of factors. P/E ratios vary widely for stocks in different countries, in different industries, with different histories, with different headline news about them, with different management teams, and so on.
On a very large scale, however, it’s possible to calculate the P/E ratio of an entire index or an entire stock market. This large average gives an impression of the overall sentiment of investors about stocks and how well they are faring in the ongoing “beauty contest” with bonds. As of this writing, the P/E for the S&P 500, based on a broad consensus of earnings over the next four quarters, is 16.8.
A related barometer — and one that is significant because of its importance in the thinking of large institutional investors — is stocks’ dividend yield. A stock’s price also reflects how much an investor is willing to pay today for the future flow of dividends from that stock. For the S&P 500, the dividend yield is currently just over 2%; the Dow Jones, which is comprised of larger, more dividend-oriented stocks, is at about 2.4%.
Today, bond returns are not yet high enough to compete with stocks, whose total return is derived from both dividends and price appreciation on the basis of earnings growth. That is, in the “beauty contest,” investors are constantly comparing bonds’ interest rates to stocks’ P/E ratios and dividend yields.
During the past nine years of extraordinarily low interest rates, capital that had been allocated to bonds found its way into stocks, as stocks appeared relatively more attractive. As interest rates have risen rapidly this year, some investors — those with a more short-term trading orientation who are more easily alarmed by the pace of the rise — have begun to reverse this process. This helps account for the long, sideways correction that the U.S. market has been experiencing since January. Clearly, the rapid increase in interest rates is causing many investors to reconsider the P/E ratio they will accept, and the dividend yield they will demand from their stock investments.
Earnings and Economic Growth
As interest rates continue to rise, stock prices will therefore continue to come under pressure. In order for stock prices to continue to rise in the face of rising interest rates, investors must believe that the “E” of the P/E ratio — earnings — is going to rise faster than interest rates will. In order to believe that, they must believe that inflation and economic growth will be robust. (As an aside, the initial wave of first-quarter corporate profits are in, and they are very strong. And as readers know we are bullish on profits throughout 2018, expecting them to grow at a 20% rate.)
Two-year U.S. Treasury bonds currently yield 2.47%. As bond yields rise, and two-year bonds exceed 3 and 4%, short-term bonds increasingly become interesting alternatives to dividend-paying stocks. That threshold will be passed in 2019.
We’ve discussed the impact on stock prices of earnings and interest rates. In our view, earnings and their growth rate are the most important determinants of stock prices. Interest rates come second. If interest rates were flat, stock prices would theoretically rise at the same rate as earnings growth — currently expected to be about 20% this year for the S&P 500.
In the real world, though, a 20% increase in earnings this year will not necessarily translate to a 20% rise in stock prices. For example, if higher interest rates caused P/E ratios to fall from 16.8 to 15.8, a 20% increase in earnings would lead to a 14% increase in stock prices. So a rising interest-rate environment — in which bond values are of course falling — can be good, bad, or neutral for stocks, depending on other circumstances.
All of this is further complicated by the outlook for the rate of change of interest rates and P/E ratios in 2019.
The calculus of values in the stock market remains as changeable as it has always been. Although many try to predict market direction, duration, and distance based on interest rates and earnings growth, investors must also consider many psychological variables. Psychology is critical, because in the last analysis, valuations are based not simply on rational and objective study of current and past reality, but on market participants’ anticipation of the future.
In short, there is no magic formula. Rest assured we give consideration to the factors discussed above, as well as many other economic, social, technological, and political signs and developments. Today, the weight of the evidence — particularly the current response of the market to the rapidity of interest-rate increases — is moving toward an expectation that a recession in the U.S. is some time away. The current markret fear assumes that the economy will implode in the near future; that is not in the cards.
Global Events and Trends
There have been historical periods of high interest rates during which businesses were eager to borrow money for expansion, because robust inflation and economic growth led them to the conclusion that such borrowing would yield more than it cost.
In our view, the events taking place in other economies or in the global political sphere will be the causes of the recession — and that the recession is still some time away. We have often said that “bull markets do not die of old age; they are killed by recessions” and that “recessions are caused fundamentally by credit contraction.” We can envision a variety of global financial, economic, and geopolitical events which could have these effects on U.S. financial markets — for example, a European banking crisis; a sudden slowdown in Chinese growth precipitated by a disorderly deleveraging in the Chinese financial system; a geopolitical event in Iran or North Korea; or even a too-rapid spike in oil prices.
We will be sure to prepare for the recession in advance of the crowd, and in spite of our traditional caution we are confident that a recession is not imminent.
As we commonly do in declining markets we are holding more cash and are purchasing short-term debt instruments in the form of U.S. treasury money market funds for managed accounts. If interest rates continue to rise more rapidly than stock earnings growth, we will buy more short-term debt instruments for our clients. When the balance between investment return plus dividends from stocks is inferior to that of bonds, we will hold short-term bonds in U.S. and foreign currencies. And should the prospects for both stocks and bonds be unsatisfactory, there are other options still — including both precious metals and U.S. and foreign currencies.
It is now obvious that the U.S. stock market has been under pressure since January essentially because of rising interest rates, and particularly because of the speed with which interest rates have risen, and the magnitude of this move relative to their recent history. The behavior of the market under these conditions has made us more attentive to the risks posed should inflation and economic growth expectations decline. We are holding a high percentage of cash in the managed portfolios because of our current concern. When fear begins to recede, we will once again buys stocks that are in sectors of the economy which can do well in the current market environment.
Investment implications: The U.S. market remains locked in a tug-of-war between rising interest rates and rising earnings. The current fear making the rounds is that U.S. earnings have hit their “high water mark.” Ultimately, clarity will come as investors make judgments about the global landscape of growth and inflation. Those judgments will translate into price-to-earnings ratios that they are willing to pay, and dividend yields they will demand. The price-to-earnings ratio for U.S. stocks will compress as interest rates continue to rise — but how much? That in turn depends on interest rate, growth, and earnings outlooks for 2019 — which could be affected by many different economic, financial, and geopolitical events. The fundamental bull thesis has not been derailed, but as interest rates obviously take center stage in investors’ thinking, investors should monitor these factors closely.
To learn more about Guild Investment Management, please go to www.guildinvestment.com.
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