Quarterly Newsletter July 1, 2015
Thinking about the next 5 years, we wonder what will happen to inflation and interest rates. As you know, the Federal Reserve has held rates down close to 0% for an extended period of time to stimulate the economy. The graph below shows the 90-day Treasury bill yield, the 10-year Treasury bond yield, and the S&P 500 price:
This is a graph we show at most of our customer seminars. Interest rates peaked 35 years ago in 1980. The last 3 recessions are shaded on the graph. You will notice that, prior to each recession, short-term interest rates rose relative to long rates, to the point that the short rates became higher than the long rates. Subsequent to this yield curve inversion, the recession commenced.
The stock market, however, continued to rise along with interest rates as the Federal Reserve raised rates. The Fed might start raising short-term interest rates at their September meeting. If they do, and the stock market follows its historical path, we should have several more years of positive markets.
The green line on the chart shows short-term rates have been close to 0% for the past 6-7 years. We have never had short-term interest rates flat-line like they have in this cycle. Historically they are always moving either up or down, not sideways. The market has performed quite well over this 6-7 years of near-0% interest rates.
The really big question today is how much has the market relied upon 0% interest rates? As we start our journey on the path of higher interest rates, only time will provide the answer. There is obviously speculation in parts of the market, like biotechnology, where companies with no sales, let alone earnings, are trading or are being gobbled up for billions of dollars of market capitalization. At the same time, most high-quality, core-type stocks are selling for reasonable multiples of earnings. The chart below shows historical P/E ratios at different levels of inflation. Today’s P/E of 18 on the S&P 500 is right at historical levels.
S&P 500 Average P/E (1950 – current) for CPI inflation ranges
Most investors use interest rates in their valuation calculations. When interest rates are low, income-producing investments like stocks are more competitive. At the present time, our core stock dividend yields are higher than those of most bonds. As interest rates increase over the next several years, bonds will become more competitive with stocks. We anticipate the vast majority of our companies will keep increasing their dividends, given their low payout ratios, strong balance sheets and historically high levels of cash. Therefore, treasury bond yields would need to rise a lot to surpass dividend yields.
The stock market has been in a trading range this year as investors look ahead to the Fed. But the Federal Reserve should be viewed as quite conservative and will only start (or keep) raising interest rates if they are confident the economic recovery is sustainable. If history is a guide, the market will be just fine as we travel the path toward normalized interest rates. Stocks have also reacted to stalled corporate profit growth, due to the strong dollar and falling oil prices. We believe these are near-term issues which will end up as long-term positives for the economy.
We are well aware the market has been very strong in the last 6 years and we attempt not to be complacent. As our friends at Strategas remind us, it is easier to make money when things move from terrible to just bad, than when things are going from pretty good to good. As long-term investors, we still believe, even with the Dow at 18,000, you should maintain a relatively full position in high-quality equities.
– written by David Meyer