April 2011: Interest Rates, Valuations and Expected Returns

Interest Rates, Valuations and Returns

Overview:  Interest rates influence asset valuations, and asset valuations imply future expected returns.  The future return from an asset is largely a function of how cheap or how expensive that asset is now.  When interest rates are high, assets are generally priced cheaply (low valuations) and future returns are likely to be above average.  Conversely, when interest rates are low, assets are generally priced richly (high valuations) and future returns are likely to be below average.

Our Objective:  We have purposefully simplified this discussion, choosing to approach it from a “big picture” perspective.  Our objective is to provide an understandable grasp of how general levels of interest rates relate to investment valuations and expected future returns.  More importantly, we will apply this to current valuations and what those valuations imply about future returns.  We believe this is an important and timely message for our clients.

What is an “interest rate”?   Think of an interest rate as the expected return or profit on an investment.  The terminology for this is different for a bank CD, a bond, a stock, and real estate, but the concept is the same --- they are all crude indications of the level of return (profit) to be expected.

When interest rates are high, that’s another way of saying expected returns on capital are high.  Whether talking about CDs, bonds, stocks or real estate, when the expected returns on capital are high, valuations are low (cheap), and implied expected future returns are above average.  Conversely, when interest rates are low, that’s a way of saying expected future returns on capital are low and valuations are high (expensive).

Cheap vs. Expensive: In 1981 short-term interest rates were 18%, long-term treasury bonds yielded 14%, and stocks had a low P/E ratio of just 8.  Asset prices were low and their implied future returns were high (and, in fact, produced exceptionally high returns). Conversely, when an asset is priced richly (high valuation), interest rates are generally low and future returns are likely to be below average.  Currently, short-term interest rates are less than 1%, long-term treasury bonds are under 5%, and stocks sport a high P/E ratio of 18.

We are currently in an ultra-low interest rate environment.  Asset valuations are high.  This implies that future returns will be low.  That’s what happens when assets are richly priced.  Buying at low prices (low valuations) provides a much better shot at a high return than buying at high prices (high valuations).  History and common sense confirm this.

Federal Reserve Policies (Quantitative Easing, Round 2; “QE2”): Current Federal Reserve policies have been largely responsible for the current state of financial markets --- ultra-low interest rates and rising asset prices.  It wouldn’t be far-fetched to call this the “Ben Bernanke Bubble.” The Federal Reserve has been creating additional demand for assets by printing money and buying roughly $100 billion of government bonds per month.  They create money electronically for the Federal Reserve’s account, then go into the market place and buy government bonds with the newly created money.  This props bond prices up (i.e., holds interest rates down).

That’s just the first step.  What else happens?  Former holders of the bonds purchased by the Fed have exchanged their bonds for cash.  The former bond investors that cashed out are then faced with the dilemma of investing their cash in a near-zero interest rate environment.  So, what do they do?  Because cash returns are so meager (a purposeful consequence of Federal Reserve policy), the new holders of cash use it to buy investment assets, such as stocks and commodities, exerting additional demand on those assets and thereby driving their prices higher (explaining rising stock and commodity prices since QE2 was announced last August).

But, that’s not the end of it.  When investors put cash to work it doesn’t reduce the amount of cash in the system, it merely passes the cash around from one person to another.  Although the buyer of the stock or commodity reduced his cash balance, the seller increased their cash balance by an identical amount.  The media is often guilty of glibly proclaiming that “cash on the sidelines is going into the market.” This is incorrect and misleading.  Every dollar a buyer puts into the market is a dollar taken out of the market by a seller.  You can’t have a buyer without a seller. It’s a giant game of hot-potato, except the potato is cash.  The aggregate amount of cash in the system is unchanged.  It is merely passed around.  The amount of cash in the system cannot be increased or reduced unless the Federal Reserve adds or depletes cash from the system.  The Fed’s policies of Quantitative Easing have served to flood the system with ever increasing amounts of cash.

With interest rates at such unattractive ultra-low rates, the inducement to get rid of cash and into assets like stocks and commodities becomes great, thus bidding prices higher and higher. Meanwhile, the Federal Reserve continues to pump roughly $100 billion a month more into the system, intensifying the game of hot-potato.

Here’s the rub --- higher prices mean higher valuations and higher valuations mean lower future returns.  As stock and commodity prices rise to ever higher levels, expected future returns are correspondingly reduced.

What Should a Prudent Investor Do?  Should you abandon caution and jump into the fray and buy already richly priced assets with the hope that they will become even more richly priced (can you say “speculate”)?  Or, do you continue on a more conservative and prudent path with a reduced exposure to stocks and commodities, knowing that the surge in speculative demand caused by the Federal Reserve’s stimulus program is temporary and will unravel when those policies end or when prices reach an obviously absurd level?

Returning to the Beaten Path (Mean Reversion):  From time to we hear someone suggest, “This time it’s different.”  It’s never different.  It’s always the same because the human follies of greed and fear are always the same.  As Sir John Templeton famously said, “The four most dangerous words in investing are, ‘This time it’s different’”.  An abandonment of concern for valuations will not end well.  Think internet stocks in the late 90’s.  Think real estate in the early 2000’s.  Investment markets can throw some wild stuff at you, but ultimately they always gravitate back toward normalcy.

Investing In Today’s Environment: We have avoided the speculative surge that started to gain momentum last summer in anticipation of round two of the Fed’s Quantitative Easing program.  Our reasoning was simple; we can’t simultaneously be conservative and take on speculative investment risk.  It’s one or the other.  We chose the more prudent path.

Alternatively, in lieu of jumping on the bandwagon of the Fed-induced Bernanke Bubble, we adopted an investment in foreign bonds that has the potential to continue benefiting from our government’s policies that are devaluing the dollar.  We’ve noticed recently that when the stock market falters this investment has been making above average contributions toward the stability and profits of our portfolios.  This has provided us with a profitable, yet more conservative alternative to buying richly priced stocks and commodities.

Aesop Had It Right:  Slow and steady does win the race.  It is interesting to note that since adjusting our investment strategy in late 2004, the stock market trails the cumulative performance of our portfolios, notwithstanding the stock market’s tremendous rally the past two years.  Our portfolios are ahead overall because we chose a more conservative, prudent path that meant our portfolios, unlike the stock market, did a better job of protecting capital and, therefore, did not need extraordinary returns to recover lost ground.

The four cornerstones of our investment strategy --- balance, diversification, moderation and patience – have and will continue to serve us well.  We thank you for your continued business and the trust and confidence you have placed in us by allowing us to work with you and manage your capital.  We look forward to continuing our journey together, anticipating and addressing new developments, adapting to foreseen and unforeseen challenges, and succeeding together. ***
Greg Schultz & Bruce Grenke

© Asset Allocation Advisors, Inc. 2011