Tag Archives: economy

Why Low Interest Rates Do Not Imply Perpetual Increases In Stock Prices

Some investors have come to believe that ultra-low interest rates alone have made traditional valuations obsolete. The irony of the error in judgment? Experts and analysts made similar claims prior to the NASDAQ collapse in 2000. (Only then, it was the dot-com “New Economy” that made old school valuations irrelevant.) The benchmark still trades below its nominal highs (and far below its inflation-adjusted highs) from 16 years ago. Without question, exceptionally low borrowing costs helped drive current stock valuations to extraordinary heights. In fact, favorable borrowing terms played a beneficial role in each of the stock bull markets over the last 40-plus years, ever since the post-Volcker Federal Reserve began relying on the expansion of credit to grow the economy. Indeed, we can even take the discussion one step further. Ultra-low interest rates had super-sized impacts on the last two bull markets in assets like stocks and real estate. Bullishness from 2002-2007 occurred alongside household debt soaring beyond real disposable income ; excessive borrowing at the household level set the stage for 40%-50% depreciation in stocks and real estate during the October 2007-March 2009 bear. Bullishness from 2009-2015 occurred alongside a doubling of corporate debt – obligations that moved away from capital expenditures toward non-productive buybacks and acquisitions. Would it be sensible to ignore the near-sighted nature of how corporations have been spending their borrowed dollars? Click to enlarge It is one thing to recognize that ultra-low borrowing costs helped to make riskier assets more attractive. It is quite another to determine that valuations have been rendered irrelevant altogether. For one thing, the U.S. had a low rate environment for nearly 20 years (i.e., 1935-1954) that is very similar to the current low rate borrowing environment. The price “P” that the investment community was willing to pay for earnings “E” or revenue (sales) still plummeted in four bearish retreats. In other words, low rates did not stop bear markets from occurring in 1937-1938 (-49.1%), 1938-1939 (-23.3%), 1939-1942 (-40.4%), or 1946-1947 (-23.2%). Click to enlarge Economic growth was far more robust between 1936 and 1955 than it is in the present. What’s more, during those 20 years, valuations were about HALF of what they are today. If low rates alone weren’t enough to DOUBLE the “P” relative to the “E” back then, why would one assume that low rates alone right now are enough to justify exorbitant valuations in 2016? When top-line sales and bottom-line earnings are contracting? When economies around the globe are struggling? Equally important, the inverse relationship between exorbitant valuations and longer-term future returns since 1870 has taken place when rates were low or high on an absolute level; the relationship has transpired whether rates were falling or rates were climbing. It follows that central bank attempts to aggressively stimulate economic activity and revive risk asset appetite did not prevent 50% S&P 500 losses and 75% NASDAQ losses in 2000-2002, nor did aggressive moves to lower borrowing costs prevent the financial collapse in 2008-2009. Clearly, valuations still matter for longer-term outcomes. In all probability, in fact, fundamentals began to matter 18 months ago. Take a look at the performance of the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) versus the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ) over the 18 month period. Even with borrowing costs falling over the past year and a half – even with lower rates providing a boost to corporations, households and governments – “risk on” stocks have underperformed “risk off” treasuries. It gets more interesting. The prices on riskier assets like small caps in the i Shares Russell 2000 ETF (NYSEARCA: IWM ), foreign stocks in the Vanguard FTSE All-World ex-US ETF (NYSEARCA: VEU ) and high yield bonds via the SPDR Barclays Capital High Yield Bond ETF (NYSEARCA: JNK ) have fallen even further than SPY. In complete contrast, the price of other risk-off assets – the CurrencyShares Japanese Yen Trust ETF (NYSEARCA: FXY ), the iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ), the SPDR Gold Trust ETF (NYSEARCA: GLD ) have surged even higher than IEF. By the way, 18 months is not arbitrary. That is the period of time since the Federal Reserve last purchased an asset (12/18/2014) as part of its balance sheet expansion known as “QE3.” Since the end of quantitative easing, then, indiscriminate risk taking has fallen by the wayside. Larger U.S. companies may have held up, though the prospect for reward has been dim. Smaller stocks, foreign stocks and higher-yielding assets have not held up particularly well; their valuations may be on their way toward mean reversion. In the big picture, then, are you really going to get sucked in to the idea that low rates justify perpetual increases in stock prices? The evidence suggests that, until valuations become far more reasonable, upside gains will be limited. Additionally, until and unless the Federal Reserve provides more shocking and more awe-inspiring QE-like balance sheet expansion a la “QE4,” where the 10-year yield is manipulated down from the 2% level to the 1% level, low rate justification for excessive risk-taking would be misplaced. What could the catalyst be for indiscriminate risk taking? What could spark a genuinely strong bull market uptrend? Reasonable valuations that are likely to result from a bearish cycle. Fed policy reversal might then force the 10-year yield to 1% or even 0.5%, and we could then discuss how they “justify” still higher valuations than exist in 2016. Nevertheless, unless the Fed has found methods for eliminating recessions outright and permanently inspiring credit expansion, bear markets will still ravage portfolios of the unprepared investor. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

Gamable EPS And Share Buybacks

EPS (Earnings per Share) is a corporate metric that is often pursued by the corporate managers and executives to increase their own payouts, and confused by investors for a signal of company health. As is well known (and we show this in our Risk & Resilience course), EPS is a “gamable” metric – in other words, it can be easily manipulated by companies, often at the expense of actual balance sheet quality. And I have written about this problem here on the blog for ages now. So, here is a fresh chart from the Deutsche Bank Research (via @bySamRo) detailing share buybacks’ (repurchases) contribution to EPS growth: In basic terms, there is no organic EPS growth (from net income) over the last 7 quarters, on average, and there is negative EPS growth from organic sources over the last 4 consecutive quarters. As noted in my lecture on the subject of “EPS gaming”, there are some market-structure reasons for this development (basically, rise of tech-based services in the economy): Click to enlarge Source of Data: McKinsey Click to enlarge Source: McKinsey However, as the chart above shows, share buybacks simply do not add any value to the total returns to shareholders (TRS), and that is before we consider a shift in current buybacks trends toward debt-funded repurchases. So, in a sense, current buybacks are rising leverage risks without increasing TRS. Which is brutally ugly for companies’ balance sheets, and given debt covenants, is also bad news for future capex funding capacity.

The Leap Year Approach To Investing

This year (2016) marks another special year for those who happened to have a significant event, like a birthday or wedding anniversary, fall on February 29th. The Leap Year, which is that extra day that we get every 4 years to help align our calendar year with an actual solar year (which happens to be 365.25 days), is upon us yet again. While many of us might just see this as just “another day,” there are some real advantages to having four-year intervals in our lives. We propose that one of them is looking at your investment performance, assuming you are in a target date fund or have a passive advisor handling rebalancing, tax-loss harvesting and a glide path strategy for you. Now this might sound a bit loony, but there is some real truth into what we are proposing. First of all, it allows investors to drown out the daily “noise” that the prognosticators, the “professionals,” and the entertainers are delivering across the many media outlets. These outlets have become experts in delivering second by second accounts of random news stories and extrapolating them into “advice” with an overlay of overconfidence, as if their ability to estimate market values and future events has the same precision as a Swiss watch. Unfortunately, many soothsayers are more often wrong than they are right , but the short-term attention and amnesia that affects all of us humans allows us to forget and repeat. Once we take a big step back from the second by second clutter, we are able to take a deep breath and really see the irrelevance of it all. A Leap Year approach to investing is the embracing of this emancipation. Now there is nothing unique to this approach in which we are trying to find some long-term market-timing trend that will allow you to outperform the market. Quite the contrary! This is about resetting your internal investment clock to be thinking in years — many years, that is — instead of seconds. It could have easily been the 10-Year High Reunion approach to investing or a welcome to a new decade approach to investing. But let’s be reasonable. At the end of the day, what we are really talking about is the benefit of time diversification. So what does this actually look like? Let’s assume that an investor decided to start investing back on March 1, 1928 and made an agreement with their investment advisor to not discuss nor look at any performance figures until February 29th of the next Leap Year. May seem very unrealistic, but not as much as one would think. Unless something dramatic changes in somebody’s financial situation (this does not include fear due to a short-term downturn in the market), then it doesn’t seem so unrealistic that a 4-year window to chat and reassess could be practical. There may be things going on in the background like rebalancing and tax-loss harvesting, but we are just talking about looking at performance and reassessing financial goals. Using historical performance data for IFA Index Portfolio 100 from March 1, 1928 through February 29, 2016, we have 22 independent 4-year time periods ending on a Leap Year (see table below). We know that past performance is no guarantee of future results, but we are going to be speaking more about the overall trend versus specific numbers. For example, over all 22 4-year periods, the average 4-year annualized return was 11.50%. The lowest 4-year period was during the Great Depression (1928-1931) where we saw an annualized return of -23.50%, or a painful total loss for the 4 years of 65.74%. This was subsequently followed by the highest 4-year annualized return (1932-1936), where we saw a 32.48% annualized return, which amounts to a total return of 208.06%. This would have gotten an investor back to the original investment amount from March 1, 1928 (8 years earlier). The third lowest Leap Year annualized return ended on February 29, 2012, which included the global financial crisis of 2008-2009, but still ended up with a 12.6% total return for the period. Let’s digress on this just a little bit. If we were to focus on the day-to-day news stories and volatility during that time, which included the fall of Bear Stearns and Lehman Brothers as well as the bailout of the biggest financial institutions in the world, like AIG, and the economy had lost 800,000 jobs per month, we would have expected a much different story. It was a warzone. But once we expand our view, even during a very distressing time like 2008, it was just a blip. Out of the 22 independent Leap Year periods, there were only 2 (9%) that had negative returns (both in the 1928 to 1940 period) and no negative Leap Year period returns since 1940. Leap Year Returns of IFA Index Portfolio 100 88 Years (1/1/1928 to 12/31/2015) 22 Leap Years 4-Year Leap Year Periods Annualized Return Total Return March 1, 2012 – February 29, 2016 6.18% 27.09% March 1, 2008 – February 29, 2012 3.02% 12.64% March 1, 2004 – February 29, 2008 10.54% 49.33% March 1, 2000 – February 29, 2004 9.82% 45.43% March 1, 1996 – February 29, 2000 12.12% 58.04% March 1, 1992 – February 29, 1996 13.92% 68.44% March 1, 1988 – February 29, 1992 13.82% 67.81% March 1, 1984 – February 29, 1988 22.54% 125.46% March 1, 1980 – February 29, 1984 18.49% 97.09% March 1, 1976 – February 29, 1980 21.46% 117.63% March 1, 1972 – February 29, 1976 3.23% 13.56% March 1, 1968 – February 29, 1972 9.55% 44.05% March 1, 1964 – February 29, 1968 18.29% 95.77% March 1, 1960 – February 29, 1964 9.09% 41.65% March 1, 1956 – February 29, 1960 10.39% 48.49% March 1, 1952 – February 29, 1956 19.22% 101.99% March 1, 1948 – February 29, 1952 18.44% 96.78% March 1, 1944 – February 29, 1948 13.81% 67.77% March 1, 1940 – February 29, 1944 13.32% 64.88% March 1, 1936 – February 29, 1940 -3.14% -11.98% March 1, 1932 – February 29, 1936 32.48% 208.06% March 1, 1928 – February 29, 1932 -23.5% -65.74% Source: ifacalc.com , ifabt.com , Index Fund Advisors, Inc. We could also take a look at the monthly rolling 4-year returns from 1928 to 2015. This would include 1,009 4-year monthly rolling periods. The median annualized return across all 1,009 4-year periods was 13.42%. The lowest 4-year period was 06/1928 to 05/1932, where we saw an annualized return of -36.73%. Similarly to our observation before, the highest 4-year return came soon thereafter (03/1933 – 02/1937) where we saw a 56.22% annualized return. Click to enlarge Click to see the full interactive chart on IFA.com . The Leap Year Review approach to investing is our way of resetting our investors’ internal investment clocks. Investing is not about thinking in seconds, minutes, hours, days, weeks, months, or even 4 years. There is too much randomness to extract anything of benefit from these types of time periods. Having a broader focus allows investors to tune out the irrelevant. This will help to protect investors from becoming victims of their own emotions. We have shown using historical data the benefits of time diversification . Of course this doesn’t mean that the future will be so bright, but remember, from 1928 to 2016 there have been multiple wars, conflicts, economic booms and busts, stagflation, and differing economic policies (think FDR versus Ronald Reagan). Through all of this, markets have rewarded the patient investor. Believing that somehow this is going to change in the future is pure speculation. Happy Leap Year! Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.