The same low-interest-rate famine that is turning retirees into fearful serfs has made stock investors richer.
It doesn’t seem quite right, but that’s the way it is.
When common stocks have no competition, they go up in value. That, more than expectations of a glorious, strife-free future, is what has caused the most amazing stock market recovery in my half-century of investing experience.
… when stocks had lots of competition
You can understand this by doing a little time travel with me. We’ll revisit the 1970s and early 1980s. Back then, stocks had some real competition. You had to choose between the earning power of stocks and the earning power of bonds or money market funds.
By the end of the 1970s, stocks couldn’t get in the ring. Interest rates did a knockout.
Interest rates started to rise in the early 1970s. Some believe it happened because of the first OPEC embargo, the sudden increase in the price of oil and the rising inflation it caused. Others say it happened because President Richard Nixon took the United States off the gold standard by refusing to exchange gold for dollars. They say being off gold caused inflation.
Either way, inflation rose. It rose year after year. Interest rates rose with it.
Amazing interest rates
By the early 1980s, money market funds, the investment darlings of the previous decade, were sporting yields as high as 18 percent. At the peak in January 1981, 10-year Treasury bonds were yielding 15.41 percent.
Yes, you read those numbers right: 18 percent on money market funds, 15.41 percent on 10-year Treasurys.
Think about that deal. On the one hand you have a monthly payment of pretty secure interest that you can write checks against. On the other, you’ve got common stocks with uncertain earnings and uncertain dividends that don’t come near an 18 percent yield.
When people sold stocks and bought money market funds
What can people do?
People responded exactly as you would expect. They didn’t buy stocks. Why bother? They sold them. They also sold their mutual funds that invested in stocks. Corporate America was in liquidation.
That was when the cover of Business Week declared the stock market was dead. (It wasn’t. It just looked that way.)
Ever since then, the interest you could earn on cash, savings or bonds has been declining. Today, interest rates are lower than any time in living memory. They are low in nominal terms. They are a losing proposition when you subtract the inflation rate.
But this is now…
As I write this, for instance, the yield on a 30-year Treasury bond is 1.52 percent, an upward bump from 1.35 percent. The yield on a 10-year Treasury bond is 0.74 percent, up from 0.65 percent. (The upward bump in a week is attributed to the change in Federal Reserve policy.) Meanwhile, the inflation rate over the last 12 months is 1 percent, according to the U.S. inflation calculator. So safe-interest-rate investing is pretty much a losing proposition. You get paid a pittance in interest, you pay taxes on it, and what’s left doesn’t compensate for inflation.
You also need a major fortune to earn a minor income. Here’s an example.
According to ZipRecruiter, if you worked as a cashier at a McDonald’s in Dallas, you’d earn $44,568 a year. Nationally, you’d earn $33,834. To replace your Dallas wage, you’d need a cool $6,022,703 in Treasurys. Nationwide you’d need “only” $4,572,162. (To get a more complete idea of how interest rates and stock yields have affected the nest egg you need in retirement see the recent update of my Life of Riley Index.)
With interest rates on savings providing less and less interest rate competition for stocks, we can expect that people will pay more for a dollar of corporate earnings. Economists at the Federal Reserve thought that was an idea with merit. The so-called “Fed Model” was shown to be a reasonable proxy for stock valuations.
The problem with models
The only problem?
It was a model. Push the numbers beyond their ordinary range and lots of models just blow up.
That’s what happened with what market observer Ed Yardini calls the Fed Model. It said that history showed that the earnings yield for common stocks (earnings/price) was closely associated with the yield on 10-year Treasurys.
That was fine when yields were in the range of historical norms, 5 or 6 percent.
Try it for yourself. When the yield on a 10-year Treasury was, say, 6 percent, the expected earnings yield (Earnings/Price or E/P) on stocks would be close by, about 6 percent.
Not familiar with earnings yield? No problem. We see another metric more often: the price earnings ratio or P/E. Divide the earnings yield into 100 and you get a P/E ratio around 16 or 17.
But at 0.74 percent for a 10-year Treasury, the whole thing blows up.
An earnings yield of 0.74 percent is equivalent to a P/E ratio of 135. That’s about 9 times normal P/E ratios. It’s up there with Amazon (134) and Netflix (92). Other valuation models have the same problem.
What’s the take away here?
Be wary
Caution, not daring, is your friend.
Stock prices are high because there is no financial competition. That doesn’t mean they are great buys.
The bottom line?
Less in stocks could mean more in principal. Even if you have to spend a small amount of principal to pay your bills, it may be better than losing a lot of principal in a major market decline.
Related columns:
Scott Burns, “Covid-19 Blew Up the Life of Riley Index,” 7/4/2020 https://scottburns.com/covid-19-blew-up-the-life-of-riley-index/
Sources and References:
Tim Keefe, “Breaking Down the Fed Model,” 6/15/2019
https://www.investopedia.com/articles/stocks/08/fed-model.asp
Yardini Research, Inc., “Stock Market Briefing: Fed’s Stock Valuation Model Monthly/Weekly,” 8/24/2020 https://www.yardeni.com/pub/valuationfed.pdf
Barry Ritholtz, “Death of Equities 40th Anniversary,” 8/13/2029 https://ritholtz.com/2019/08/death-of-equities-40th-anniversary/
Department of the Treasury website, Daily Treasury Yield Rates, https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/textview.aspx?data=yield
FRED Economic Data from the Federal Reserve Bank of St. Louis, 10-Year Treasury Constant Maturity Rate. https://fred.stlouisfed.org/series/DGS10
U.S. Inflation Calculator: https://www.usinflationcalculator.com/inflation/current-inflation-rates/
ZipRecruiter website on McDonald’s Cashier salaries: https://www.ziprecruiter.com/Salaries/Mcdonalds-Cashier-Salary
This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
Photo by Guy Kawasaki from Pexels
(c) Scott Burns, 2020