Entering February, the Federal Reserve will have a new chairman for the first
time in nearly two decades as Ben Bernanke will replace Alan Greenspan. This
position is often called the “second most powerful position in the world”.
In assessing Greenspan’s legacy, at this point, one can
only say “so far, so good.” Inflation and interest
rates are low, we are in an extended economic expansion, recent
recessions have been shallow and short, major financial market
debacles have been managed, and we have a general overall environment
of economic and market stability. However, there are a number of
colleagues in the industry, whom we respect, who take much more
extreme views of Greenspan’s record. Some rave about his
performance, while others feel he has made massive mistakes. Perhaps,
like raising a child, the better measure of a parent’s success
is how the child ends up decades after he’s left the house.
Right now, Greenspan’s record looks good. But there are
some lingering issues from his tenure, and how they are eventually
resolved may truly define his place in history. First, there is
the open question of potential asset bubbles, such as housing,
that have been inflated by extraordinarily low interest rates.
There is massive consumer debt levels, again created by easy liquidity
conditions. Other economic concerns include the triple deficits – federal,
trade, and future pension obligations. While it is unfair to dump
all of the economy’s potential problems on any one person,
such as the Chairman of the Fed, it’s a convenient place
to start assigning accountability. To be fair, Greenspan did a
fine job navigating these problems while he was the chairman.
Ben Bernanke is the new chairman of the Federal Reserve. We have
already discussed our generally positive views of Bernanke earlier
in this space, noting that we felt that the market’s apparent
initial sense that Bernanke would be too easy on inflation was
off base. In our view, we believe that Ben is properly concerned
about price stability, which is actually one of the Federal Reserve’s
goals, where fighting inflation, per se, is not.
The Federal Reserve’s responsibilities fall into three broad
categories: (1) managing the nation’s supply of money and
credit (“monetary policy”), (2) regulating certain
banking institutions to ensure their safety and soundness, and
(3) serving as a bank for depository institutions and the federal
government. Most people think that the Fed’s primary job
is simply the first point – monetary policy. And, when it
comes to monetary policy, most think it is simply just about combating
inflation. In actuality, monetary policy has two basic goals: (1)
to promote “maximum” sustainable output and employment
and (2) to promote “stable” prices. These goals are
prescribed in a 1977 amendment to the Federal Reserve Act.
Stable prices are a key point here. That means worrying about
preventing prices from falling (deflation) as much as rising (inflation).
But while there has indeed been plenty of discussion in recent
years about deflation, it still seems that the primary concern
in the markets remains inflation. When you think about it, that’s
not too surprising. How many market participants have actually
lived during a deflationary economic environment? Very few, you
have to go back to the 1930s for that. Many of today’s investment
professionals cut their teeth in the industry when inflation was
high. Few have seen interest rates this low. It must seem natural
to expect a rotation back towards higher inflation and higher interest
rates.
Yet, there are still important and powerful deflationary forces
at work, such as globalization, significant productivity increases,
and aging populations in most developed countries. Add to that
high consumer debt levels and the lowest savings rate since 1933,
which will eventually be reconciled by reduced consumer spending,
and it is not really that much of a reach to expect that deflation
could actually be a bigger concern than inflation in the years
ahead.
And this is what makes the Bernanke selection so interesting.
He has extensively studied the Great Depression. He has studied
Japan’s deflationary problems. If there is a leading expert
on deflation, Bernanke would surely be on the short list. Also,
much has been made of his fondness for inflation targets.
But something seems to be lost in the discussions on inflation
targeting. Most people only focus on the fact that inflation would
be managed to remain below the upper boundary of the target. It
is critical to recognize that there would also be a lower boundary.
The Fed would, in fact, also be drawing a line in the sand where
they would begin to fight deflation.
While surely there were many factors used in the selection process,
was Bernanke selected to be the chairman of the Federal Reserve
in large part due to his academic and philosophical strengths and
interests dealing with deflation?
What Interest Rates Are Signaling About The Stock Market
The Federal Reserve’s primary tool for impacting interest
rates is by adjusting the Federal Funds rate, a short-term overnight
rate, which has a direct impact on other short-term rates. Longer-maturity
interest rates, however, while influenced by the Fed’s actions
and perceived motivations, are driven by the markets.
Interest rates are important to the economy and markets for multiple
reasons. Obviously, interest rates directly impact the borrowing
and spending decisions of individuals, corporations, and governments.
But the level of interest rates is also a critical input in security
valuation formulas. All else being equal, lower interest rates
positively impact economic growth and security valuations. And
falling interest rates are generally more positive for the markets
than rising interest rates.
Not only are the direction and level of various interest rates
important market factors, so are key relationships between different
interest rates (yields). Examples include: long rates versus short
rates; high quality bond yields versus low quality (“junk”)
bond yields; as well as inflation-linked government bond yields
versus “regular” government bond yields, to name a
few.
We monitor a variety of interest rate relationships to help frame
our market view. Let’s review what some of these indicators
are suggesting about the future of stock market now.
Much is made of what the Federal Reserve is doing with short term
interest rates. There is a good reason for that. Stock prices typically
follow. There is an old saying in the market: “Don’t
Fight The Fed.” In other words, if the Federal Reserve is
raising rates, generally speaking that is not a good time for the
market. If the Fed is cutting rates, the opposite is generally
true.
Standard & Poor's 500 Stock Index
[click
image for larger view - image will open in new window]
There is a lag time, however, between interest rate moves and
market movements. Thus, we have the “Three Steps and Stumble” and “Two
Tumbles and A Jump” rules, illustrated below in a chart from
Ned Davis Research. The latest Fed signal is a sell, generated
in 2004 after the 3rd hike in the Fed funds rate. So far the market
has held up well, even after 11 more rate hikes (“14 steps
and stumble?”).
Another key relationship is between short-term interest rates
(3-month T-Bill rate) and the dividend yield of the stock market.
The long-term historical average of this ratio is 1.20, that is
the yield on the 3-month T-bill (a proxy for cash) has averaged
1.2 times the dividend yield on the S&P 500. But this number
is biased downwards by the extraordinarily low interest rates and
high dividend yields during the Depression. More “normal” ratios
fall between roughly 1.70 and 2.10. If the ratio rises above that
range, then stocks are considered overvalued relative to T-Bills
and if it falls below, stocks are relatively attractive.
While this relationship has clearly been supportive for the market
for the past several years, the continuing interest rate increases
by the Fed have recently pushed the ratio into overvalued territory
at 2.49.
Standard & Poor's 500 Stock Index
vs.
Long-Term
Bond Yields/S&P Earnings Yield
[click
image for larger view - image will open in new window]
Keep in mind, that like any one indicator, it is far from perfect.
And, in fact, the prior two “sell” signals, in 1989
and 1995 were bad calls. Nevertheless, this indicator is not constructive
for the market.
However, looking at longer-term rates, the picture remains a bit
friendlier. Here we look at the yield on the 10-Year Treasury versus
the earnings yield on the S&P 500. The earnings yield is the
inverse of the P/E ratio, or a stocks earnings per share (E) divided
by its stock price (P). With its longer-term nature, rather than
just examine the ratio between the two yields, the indicator we
look at here is the six month (26 weeks) rate of change in the
ratio.
Currently that indicator is in the neutral range, which has historically
been associated with reasonable returns from stocks averaging 8.0%
per annum.
Dow Jones Industrial Average
[click
image for larger view - image will open in new window]
The level and direction of interest rates is a critical piece
of the puzzle when examining the economy and markets. Not only
do the prices and yields of fixed income securities serve a worthwhile
purpose in a well-diversified portfolio — even at today's
low interest rates — but how they interact with other asset
classes can serve a valuable function in helping determine future
market expectations.
As always we welcome any questions and thank you for your continued
support.
Sincerely,
Eric M. KobrenRusty Vanneman, CFA
PresidentDirector of Research
Portfolio
ManagerCo-Portfolio Manager
