Investing with ZIRP

Zero Interest Rate Policy (ZIRP) is where the central bank maintains a policy of artificially low interest rates. Interest rates may not be “zero” but the idea is that they are “nominally” zero or less when inflation is considered.  Essentially, we have been in a ZIRP environment for some time.  There is no historical precedent for this environment over any significant period of time.

There is an equation, ER= I +E that can be adapted to many investment theories.  ER is “expected return”.  I is “interest” and E is “equity return from dividends and capital appreciation”. 

When discussing portfolio investment allocation, one could think in terms of the “expected return” being the sum of the return from Interest on fixed income investments (bonds) plus the return from dividends and capital appreciation applicable to Equities or stocks.   

Another use of the equation is the attempt to explain the “expected return” and valuation of a particular investment, such as Equities or stocks in general.  The “expected return” from owning equities or stocks would be the return you would get from a zero risk investment, plus the “extra” return or “risk premium” that you would earn because of the special additional risk associated with stocks.  Stocks are generally considered to be more risky than bonds and hence investors expect a higher return.

Generally, in either use of the equation, I is not zero.  But, in a ZIRP environment, it IS zero, creating some strange and unusual outcomes as well as a great deal of misunderstanding.

In the Allocation example, with I=0, ER=E, meaning the entire return from the portfolio comes from equities. In the Valuation example with I=0, ER=E meaning the expected return of the investment is equal to the “equity risk premium” associated with owning stocks.

History teaches us that the “equity risk premium” or ERP for stocks varies depending on many factors, but generally is in the range of 5% to 8% for the “market”.  What that means is that the price of the “market” or for an “average” stock is based on the expectation that the owner will earn an average ERP of 6.5% per year over and above the % return per year for a “riskless” interest bearing investment.

So let’s say for example, we have US  10 year Treasuries (theoretically riskless in normal times) paying 5% and the ERP of 6.5%.  Then the ER or expected return would be 11.5% per year.  (This happens to be the average return from the stock market since 1900.)

Now, let’s say that US 10 year Treasuries are only paying 2.5%. One would expect the ERP to stay at 6.5% and the ER would drop to 2.5+ 6.5=9%.  But, what if people are concerned about rising interest rates, where US 10 year Treasuries could fall in value. The “riskless” interest bearing asset now becomes very short term notes that earn essentially zero interest. In this odd case, the ER would drop to 0+6.5=6.5%.

So why would stock markets rise more than 9% per year in an environment where the long term “expected return” would be somewhere between 6.5% and 9% per year?  The S&P500 rose significantly more than this in 2013 and so far in 2014.

When the alternative is 2.5% from US 10 year Treasuries, then one is paying a price of $100 for a $2.50 return or a 40 “PE” or price/earnings ratio.  In such a world, to some a price of $2000 for stocks that earn $100 seems like a reasonable “PE” of only 20. (This is about where we are right now.)

During that time from 1900 to 2014, when the market earned an average of 11.5%, the PE averaged around 15.  When market prices rise to a PE of 20, the price for a dollar of return is theoretically 30% higher than average. Put another way, the return going forward based on current prices, on a percentage basis should be expected to be 30% less---more like 8% than 11.5%.

So, no matter how you slice and dice, the reality is that a ZIRP, while providing a temporary rise in prices, essentially reduces the expected future returns from saving and investing.

Here is the most important point…

What if ZIRP is temporary and that “magic” formula of ER=11.5% with I equal to 5% and ER equal to 6.5% becomes the norm again?  That means a PE of around 15 and a dramatic drop in stock prices—even assuming that earnings and the economy remain strong.

So unless you are one who believes that interest rates will stay below their historical averages for the foreseeable future, you should assume that the S&P500 is considerably overvalued—even if earnings grow at the same time that interest rates rise.  That means that you should at least maintain a conservative asset allocation with a considerable portion allocated to fixed income.  And, a portion of that fixed income should be liquid enough to take advantage of lower stock prices when they “correct” back to more normal valuations.

This should not be considered as some form of market timing strategy because when and even if this “correction” might occur is “unknowable”. It is better to think in terms of the proven concept of rebalancing; recognizing that markets fluctuate between being overvalued and undervalued. Buying during periods of undervaluation is one of the keys to being a successful investor.

An important caution…  Interest bearing fixed income investments in a ZIRP environment can be very risky.  Bonds historically are a part of the portfolio in order to provide a stable if not even a negatively correlated return compared to stocks. But in a transition out of a ZIRP to a normal environment, BOTH stocks and many bonds will decline in value.  In such a situation, investments that are stable in a rising interest rate environment may be quite attractive and valuable.

Finally, when thinking about government sponsored ZIRP, it is true that ZIRP favors the consumer over the investor. And, since consumers and borrowers as voters outnumber investors and savers, one should be aware that ZIRP will be politically acceptable until rising prices and inflation become an issue to consumers and borrowers.

I happen to believe that one major reason we have not seen inflation, despite central bank stimulus is the simultaneous trend to force or “encourage” banks to raise capital and reduce leverage. When banks have reached the politically acceptable level of capitalization, money velocity and inflation will likely increase considerably.  When this will occur is a bit of a mystery—even to the central bankers. But, when it does ZIRP will end.

Gambler, Saver, or Investor ?

Are you a Gambler, Saver, or Investor?  The answer to that question is important yet a surprising number of people who participate in financial markets do not even know appropriate descriptions for each title.

A Gambler is someone who seeks to “make money” by placing “bets” based on speculation that their “guess” about the future is accurate. A Saver is someone who seeks to accumulate financial assets by spending less than their current income in order to fund future spending. A Saver expects that their financial assets will decline whenever they stop accumulating and begin spending more than their current income in the future. An Investor accumulates financial assets with the expectation that those assets will provide a future and rising income.

One complication is that sometimes Savers engage in gambling and sometimes Investors engage in the process of saving.  But, most people have a “preferred mindset” concerning money that defines them as being primarily a Gambler, Saver or Investor.

The study of Economics is really a social science studying aspects of human behavior.  And as an Economist, I believe that it is important for people to have an understanding of their “preferred mindset” concerning their activity as it relates to financial markets.  This “preferred mindset” will determine their emotional reaction to market fluctuation.

Keep in mind, market participants at any time include Gamblers, Savers and Investors.  Savers may not be directly participating, but since most Savers use bank accounts or insurance company products, they indirectly participate in markets through the activities of these intermediaries.  

When markets are rising, Gamblers are generally happy as most of their bets are winners. In addition, rising markets in a low interest rate environment attracts Savers seeking a higher rate of return.  Prolonged periods of rising market prices tend to generate overconfidence on the part of Gamblers and Savers.  They forget the Fundamental Law of Markets is that market prices fluctuate--UP and DOWN.

When markets decline and Gamblers begin to incur losses, they tend to try to protect their gains by “locking in” and selling.  When markets decline and Savers begin to incur losses, they tend to fear that the “climate has changed” and that the only place for “safety” is with bank deposits or insurance company products.

Investors see market declines from a different perspective.  For the same reason that people prefer good weather over bad weather—sunny days are generally more pleasant than rainy, stormy ones; Investors prefer rising markets.  What makes Investors different is that they understand that downward market fluctuations are “normal and necessary” and really are opportunities that improve the Investor’s chance of meeting their goal of future and rising income.  Investors are always potential buyers and buyers are always looking for a low price. 

Investors know that even when they are “taking income” for example while in retirement that some of their dividends will need to be “reinvested” requiring them to be buyers on almost a continuous basis.

I make no judgments as to the one title or activity being better or more  noble. There are many successful and rich Gamblers. (Although there are probably more Gamblers who lose than win.) And, if you can save enough that your future income requirements will be met, despite inflation; being a Saver provides a certain emotional comfort.  However, few can save enough to meet those future income requirements, inflation considered.

Savers  tend to seek “certainty”.  Yet funding “retirement” with a fixed savings program does not provide the “certainty” they seek.  Retirement comes with many uncertainties:  A) Lifespan; B) Income requirements given uncertain health---medical and long term care expenses; and C) Inflation.

Investors accept the reality and necessity of market fluctuation.  They realize that the present uncertainty of daily “market price” is more than offset by the probability of rising future income from “investing”. By being owners of a highly diversified portfolio of businesses they improve their chances of dealing with the future uncertainties of inflation and unknown living expenses.

It has been said that you can tell whether you are a Gambler, Saver or Investor by their emotional reaction to market fluctuations like we have seen during July-October 2014.  If the market fluctuations during the week of October 6, 2014 caused you to contemplate major liquidation so you can buy back later at a lower price, then you are probably a Gambler. If they made you feel uncomfortable, thinking that perhaps you should sell your investments and just put the money in the bank, then perhaps you are a Saver. If the recent fluctuation caused you to start thinking about what you might buy with cash you have been accumulating, then you are an Investor.

Remember that there is a big difference between those that predict market direction versus those that predict the timing of market direction.  If you think you can predict the timing of market direction, you are a Gambler. On the other hand, History has taught Investors to trust that the market direction for a portfolio of quality diversified portfolio of businesses is generally up over the "long term" of more than five year time horizons.

So, to an Investor, market fluctuations are seen as either a buying opportunity or simply the “cost of doing business”.  Everyone should be a Saver with some of their money, but for many people, being an Investor is the best way to prepare for the future.

If you are a Gambler, all I can say is “Good Luck” since I have no idea what markets are going to do tomorrow, next week, or next month. If you are a Saver, I suggest that you are underestimating the very real uncertainties of Lifespan, Health and Inflation---and suggest that you need much higher savings than you probably have accumulated---or you need to learn how to be an Investor.  As an Investor, I can say that as prices for good quality companies fall, they become increasingly more attractive to buy—hence the probability of you reaching your future income goals actually go up.

One important thing to note.  Increased use of computer software seems to have emboldened Gamblers to make bigger and bigger “bets”. This leads to the potential for an increased level of volatility and makes the market very dangerous for the small time Gambler. (On some days as much as 60% of the market volume is from Gamblers.)  It also makes the market very uncomfortable and perhaps inappropriate for the Saver.  For the Investor with the right patient and disciplined approach, this high volatility potentially creates substantially increased opportunity.

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.

The Mystery of Sustained Low Interest Rates

The terms “HQLA” and “LCR” may be a bit wonky for the typical investor, but given the effects of these terms as they have been recently placed in banking regulations, they are important.

Interest rates are extremely important. They affect the value of almost every financial asset including stocks. It has long been acknowledged that short term interest rates can be influenced, if not controlled by the Federal Reserve and other Central Banks. But, up until recently, it was assumed that Central Banks could not affect longer term interest rates---the assumption was that “market forces” of supply and demand would determine long term interest rates.  

Even Central Banks and many famous economists have been puzzled and frustrated to some extent by the fact that falling interest rates since the 2009 financial crisis have not resulted in more economic expansion and growth.

The economic “law” of supply and demand has not been repealed. Interest rates are low because the price buyers are willing to pay for a given unit of debt obligation is high.  If a “buyer-lender” or “investor” is willing to pay $100 for the promise from a debtor to pay $4.00 per year in interest, the interest rate is 4%.  If however, buyer-lenders bid up the “price” to $400 for the same promise of $4.00 per year in interest, the interest rate is only 1%.  The only way that the price can go from $100 to $400 is for there to be increased demand and/or decreased supply for interest payments. So where is this increasing demand coming from?

For a while, the Federal Reserve itself became a buyer-lender with the introduction of Quantitative Easing. They bought Government Debt with IOU's created "out of thin air". But continued QE was politically unpopular.  So the massive increase in demand created by QE is coming to an end, at least in the US. 

To replace it, a more politically acceptable way to increase demand for the interest payments from the government was devised through implementation of regulations to “insure the financial stability of banks”.  These regulations were recently finalized with minimum standards for LCR or “Liquidity Coverage Ratio”. (Rules approved September 3, requiring 80% compliance by 1/1/2015 and full compliance by 2017.) The Liquidity Coverage Ratio regulations indicate that banks are required to have a certain level of holdings defined as HQLA or “High Quality Liquid Assets”.  The most acceptable form of debt meeting the definition for HQLA?  You guessed it….Government Debt.

A recent Bloomberg article indicates banks have added $180 Billion to their now historically high government debt holdings this year. One estimate indicates that Bank of America alone will have to add $65 Billion to their government debt holdings in the future to become fully compliant with the new regulations. 

(http://www.bloomberg.com/news/2014-10-05/america-s-banks-pile-up-treasuries-as-deposits-overwhelm-lending.html)

Insuring the safety of bank deposits by requiring banks to buy government debt tends to produce low interest rates but it does not encourage any expansion in business activity. Increased savings by the public increases bank deposits and ramps up the requirement for banks to hold even more government debt.

To reverse this trend, given the current regulations, the public will need to borrow more and save less.  Borrowing more is unlikely because again, consistent with well intentioned goal of financial stability, lending standards have been tightened.  Saving less is also unlikely because people are so uncertain about the future.

Lowering interest rates as an economic policy has long been compared to pushing on a string. Economic expansion will require a dramatic change in the global population’s expectations regarding future economic opportunity and prosperity.

  

So on one hand, the government has been stimulating the economy…but on another hand it has been implementing policies to restrict credit…policies that restrain economic expansion.

Despite the probability that the Fed may raise short term interest rates in 2015, keep in mind that regulations to “insure the financial stability of banks” were put into place not just in the US, but around the world—particularly in Europe.  Interest rates in Europe and Japan are considerably lower than in the US.

Unless we see a substantial increase in “animal spirits” leading to both increased borrowing (hopefully for productive activity) and/or decreased savings, it is very possible that we will have low interest rates for a long time.  (Animal spirits is an economic term referring to people’s willingness to take risks because of an expected future economic boom.)  Of course, in such a low interest rate scenario, without such "animal spirits" we will have many banks where most of the depositor’s money is simply lent to the government.  This is a recipe for economic stagnation.

A far out possibility is that depositors tire of low interest rates and begin seeking alternatives to placing their money with banks subject to the LCR regulations--in other words with "investments" NOT subject to the LCR regs. We have actually seen a bit of this….increased demand and rising prices for dividend paying stocks.

Rising interest rates will only occur because of increased supply of interest payments (more borrowing) from borrowers and/or decreased demand for them (less lending/saving). (This is a bit counter-intuitive as popular opinion seems to assume that interest rates are low because banks are not lending. Interest rates are low because demand for interest payments from the largest borrowers, namely governments, is increasing.) $4 of annual interest would no longer fetch a price of $400. The price would need to fall perhaps back to the historical average of $100. (4% per year interest rate.)  One wonders whether the regulators considered that possibility as one can only imagine the economic effects if the value of HQLA held by banks declined significantly.

Keep in mind, more borrowing might be not because of “animal spirits” and increased productive activity, but rather because of increased borrowing by governments. Given the current situation with Social Security and Medicare, that is a distinct possibility.

So am I making a prediction?  No I am, not. There is a high probability that interest rates will stay low for longer than many expect.  But there is also a possibility that interest rates could rise significantly.  What I am warning about is a high degree of uncertainty regarding interest rates. And, where there is high uncertainty, caution is usually warranted. 

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.

Indicators of Relative Value

Often investors fail to remember the important indicators of relative value in the market. Stocks fluctuate from being undervalued to overvalued. But the definition of these terms and the boundaries are subject to debate.

One important "indicator" is the aggregate value of the stock market vs. the total value of the Gross National Product of the the US economy.  When in the graph below, the blue line (Value of Stocks) is below the red (GDP) line,  stocks generally continue to rise. When the blue line rises above the red one, a correction usually follows not too long after.

Actually, the historical average for the ratio of equity value to GDP is around 70%. (When the blue line touches the red, the ratio is 100%. Just before the correction in 2001, the ratio reached 150%. Just before the crash of 2008, it reached 112%.  The ratio is now 126%.  It has been above 100% since the beginning of 2013.

Another clue provided by the above graph can be ascertained by studying the relative movement of the blue and red lines from the late 1960's to 1980 where the value of stocks did not "keep up" with gains in the economy.  What was the cause?    The answer: RISING INTEREST RATES.  

So not only are we in a "overpriced" market, we are also at a point where rising interest rates are likely.  

It would seem that the intelligent investor should be particularly careful to search for individual stocks (and sectors) that can be purchased at reasonable prices rather than trying to follow the market.

If you were lucky enough to retire in 1982, the stock market was significantly undervalued, and we were poised for a period of falling interest rates...in other words, the perfect environment for a rising stock market and extraordinary returns.  The situation today is almost the exact opposite of the environment in 1982. 

Until we see a correction, being overweight in short term fixed income seems to be the most prudent prescription. 

Some Stats to Go with Things Seem Expensive

With reported "CPI" inflation being around 2%, let's take a look at some "price increases" June 2013-June 2014 (approximate)

Coffee                                 UP   43%
Natural Gas                        UP    26%
US Stocks (S&P500)           UP   19%
Sugar                                 UP    15%
Beef                                   UP    13%
Home Prices (US)               UP    11%
Health Insurance                 UP    11%    
International Stocks             UP    10%
Drugs (non Generic)             UP    8.5%
US Treasury Debt (10yr)       UP    7.5%
Shrimp                                UP     4%
Avg Salary                           UP    2.8%
Chicken                               UP    2%
Gasoline                             No Change!
Corn (Price to Farmer)         DOWN  30%

I'd say if the Federal Reserve is hoping for increased "inflation" by keeping interest rates low--they have accomplished their goal!  These kind of price increases lead to lower consumption and declining GDP or reduced corporate profits....or both. 

Reasonably Reliable Leading Indicator I

Years ago while at the Wharton School, my research indicated that Corporate Profits adjusted for inventory build was one of several important Reasonably Reliable Leading Indicators regarding future business activity and stock market values. 

Note that in late 2013, Corporate Profits (Not Earnings Per Share) in the aggregate declined and began diverging from the S&P500.  This trend continued and even accelerated into 2014.   This is the same pattern we saw in  2007.

Several other Reasonably Reliable Leading Indicators are not negative. But this data calls for a more careful approach until we see Corporate Profits rise for two consecutive quarters. 

This data comes from the Federal Reserve and is one reason Janet Yellen is being cautious regarding the raising of interest rates. 

We won't see the next data point until 10/30/2104. 

How did everything get expensive when reported inflation is low?

Many have been bewildered by the stock and bond markets over the past year.  This includes Nobel Prize winning economist and Yale Professor Robert Shiller who has recently been quoted as stating that the stock market, the bond market and the real estate market all seem “overpriced and expensive”.  He says he is puzzled by the phenomenon and uses the analogy of “lifeboats on the Titanic” where people are willing to pay almost any price for protection from a bad future.

Most investors have been taught that a “balanced” portfolio includes a significant portion (30-50%) invested in “fixed income” because they are told that “bonds make money or maintain their value when stocks lose money” and “bonds protect you from market fluctuations”. This is called negative “correlation”.  This teaching is not entirely correct.

Many times, bond rise in value when stocks are rising and fall in value at the same time stocks drop.  This is called positive “correlation”.  Keep in mind that bonds rise in value as interest rates fall, and vice versa: bonds fall in value as interest rates rise. (Interest rates are at historic lows meaning bond prices have risen to high levels.)

In fact, since 1927, we have had 27 periods where stock and bond correlations have shifted from negative to positive or positive to negative correlation.  Most recently, interest rates have fallen with rising bond prices right along with rising stock prices.  So both the stock market and the bond market seem to many to be overpriced and “expensive”.  In the investment world, the term “expensive” means that if you bought at present prices, your return from interest or stock appreciation would be lower than normal… OR….that prices are likely to fall from present levels.

Despite the claims by many that “markets have a lot of room to run” I think that Professor has a point.  Asset prices in general have risen quite a bit. (Home prices in the “hot” markets have risen despite the lag in other markets.)  Yet, economic conditions, while admittedly improving slowly, are far from “boom times” that would justify a rising stock market.  And, there appears to be a general sense of pessimism regarding the future by the majority of people in the developed world.

I would say that in the aggregate, people have bought the argument that wage inflation and inflation in general is subdued.  Investors are seeking income. And, when income is hard to find, they are willing to pay a premium price to get it…..high prices for bonds and high prices for stocks.  The only restraint on this behavior is fear of loss, but central banks around the world have committed publically to “do what it takes” to protect investors from losses. So, if many people buy in to the myth that inflation will be low for a long time and therefore interest rates will be low for a long time, they will pay ever increasing prices and inflate the value of every form of investment: stocks, bonds, real estate, art, and collectibles. (With low interest rates the present time value of money received in the future is higher than when interest rates are assumed to be higher.) With the exception of single family homes outside of the hot coastal markets, Professor Shiller is right, everything has gotten “expensive” except the price of an hour of human labor and an outdated plasma TV.

A balanced portfolio should have a significant portion invested in low risk investments to balance the higher risks associated with stocks.  Right now, as evidenced by the behavior of some of the world’s best money managers, that low risk investment is very short term fixed income that pays almost no interest, but does not fluctuate in value. Right now, bonds seem almost as risky as stocks. Warren Buffet’s Berkshire Hathaway currently holds almost 20% of their assets in cash!

Has this situation existed before? Can History teach us anything regarding what is about to happen? The answer is Yes and No.  People believe in myths until the myths are proven false. Remember in the 1990’s when tech stocks did not need to be profitable, they just needed to be growing?  Remember up until 2008, residential home prices could never fall?  Remember Y2K when all our computers were sure to crash at the same instant! Right now, the myth is that Central Banks can provide protection from loss by flooding markets with liquidity and that they can do so forever without creating inflation.

 

Professor Shiller is correct, we have had significant inflation in price levels.of stocks, bonds and some real estate. So, can somehow the Central Banks keep interest rates low forever?   And, if not, then when do markets abandon this myth, leading to higher wages, rising inflation, and rising interest rates---all of which will lead to lower stock and bond prices.

(My belief is that governments and Central Banks have a very limited ability in the long run to affect the economy in a positive way. They cannot control interest rates anymore than they can control currency values. Central Banks have proven throughout history that they do have one ability—to create inflation.)

By now, you should understand why market watchers sit on the edge of their seats to listen and react to every word from Janet Yellen of the U.S. Fed and every other worldwide Central Banker. The present situation is dependent on continued low interest rates and continued belief that there is little chance of loss.  It will change when one of four things happen:  1) It appears the Central Banks are going to “allow” interest rate to rise; 2) Market participants begin demanding higher interest because of higher costs; 3) Some geo-political “shock” occurs that causes investors to fear loss; and/or 4) Corporate earnings begin to fall or stagnate and investors decide to take profits, en masse to avoid losses from falling stock values.

My take is that “official” inflation is reported to be low because wages are depressed. I think Central Banks are focusing too much on the costs of labor and commodities—indicators of past cost-push inflation.  They are underemphasizing other costs of doing business. I think corporations are reaching the limits of their ability to borrow and buyback shares in order to report increased earnings per share simply by reducing shares rather than actually increasing profits. I think that rising prices will occur due to the desire and need of public companies to increase profits and these rising prices will lead to a reduction in demand. I think we are already seeing this to some degree as evidenced by struggling retailers.

You see, the average consumer is smart enough to avoid paying too high a price for goods. (Even though they may occasionally be willing to pay too high a price for an investment!)  Sooner or later, I think the market corrects with falling stock and bond prices, providing opportunity to buy attractive businesses at more attractive prices.

When exactly?  NOBODY knows. Markets could rise significantly higher from here. Be patient, careful and prudent.

Don’t assume that the above analysis means I am pessimistic. I am not. I believe that a well managed investment portfolio will produce returns over the long run consistent with historical norms. Markets fluctuate from one extreme to another. Being “well managed” does not mean that we jump in and out—it means we simply adapt to the environment in the same way we adapt and adjust to the changing seasons.