Today’s lofty stock market levels are predicated on the idea that zero percent interest rates (ZIRP) and low Treasury bond yields have made cash and bonds so unattractive that stocks are the only alternative. This is represented by the acronym TINA, or There Is No Alternative (to stocks). While it is true that lower interest rates allow for a higher valuation on a stream of cash flows, this concept of “lower rates equal higher stocks” has several notable exceptions. In addition, low rates allow companies, countries and individuals to become overleveraged. After six years and four months of a bull market in stocks, we believe it’s important to take note of the risks to the currently accepted “perma-bullish” belief that lower rates are universally good for stocks.
First, let’s address the idea that low interest rates are “always good” for stocks. If that’s the case, then how does one explain the following?
- Japanese stocks performed poorly from 1996 (Nikkei high of 22,757) through November 2012 (Nikkei low of 8,619) with the overnight rate .50% or less the whole time.
- Swiss stocks fell from above 6,000 in March ’02 to as low as 3,618 in March of ’03 with rates below 1%. In fact, stocks rallied while rates were rising from early ‘04 through ‘07. So, in this case higher rates were good for stocks.
- Italian stocks are near the same level they were back in 2009 when the ECB dropped rates to 1% for the first time. The overnight rate sits at .05% today, yet stocks have little to show for it.
I know, I know, those are countries with specific problems, and that could NEVER happen here in the good old USA. Except that it did. From 1937 until 1949, US stocks were flat with the 3-month T-bill rate below .50% the entire time.
But, if you ignore all of the times that low rates didn’t help stocks, then it’s obvious that low rates help stocks. Such is the contorted logic that when “interest rates are low, stocks will grow.” Like we said in the intro, yes, lower rates do allow a stream of cash flow to be valued higher (And stocks are, after all, a claim on a stream of cash flow).
Here are two reasons why artificially low interest rates do more harm than good. First, artificially low rates cause people, and governments, to over consume. Have you ever received a 0% interest rate offer, and bought something on credit, because if you paid it off before the teaser period was over, you got to enjoy it now? That’s basically what Japan has done since it dropped rates below 1% back in 1995. During that period of time, its debt/GDP ratio has gone from 75% to 230%. Government interest rates will never be allowed to rise there, because even at the current 0.41% 10-year interest rate, interest on its debt consumes 24% of the government’s income.
Second, low rates misallocate capital. In the last cycle, Greenspan held the overnight rate at 1% for a year, and that, in part, led to the housing bubble. Today, the dynamic duo of Bernanke and Yellen has left rates at 0% for seven years. Where has capital flowed that it otherwise wouldn’t have? It has flowed into many industries, through junk bond financing, but most visibly in oil and gas exploration. Investors who decide they can’t live on the paltry interest of 2.2% on a 10-year Treasury, have loaded up on “High Yield” and “Income” (i.e. junk bonds) funds that are loaded to the gills with 7%-10% bonds from Sandridge and Chaparral Energy to Sears and Sirius XM – a veritable who’s who of companies on the brink of bankruptcy. Many of these junk bonds are short term in nature and will require refinancing, because cash flows don’t support repayment out of profits. But, should investors abandon the sector, refinancing will be off the table, and the only option will be default creating large losses where investors thought they had safe income.
Too much debt is apparent in the junk bond sector, but it’s also apparent in China, Greece and Puerto Rico. All three suffer from the dilemma of too little income to offset debt payments. While there are likely solutions for all three, someone will have a price to pay via debt write downs, payment delays or inflation (or a combination).
Now, onto the bigger question: Do today’s high valuations on stocks matter? The short answer is no, not yet. The longer answer is yes, at some point they do. Today’s 18.4 price-to-earnings ratio is above the average of post-WWII P/E of 16, and it’s about double that of valuations at the bear market lows of seen in 1932, 1942, 1949, 1974, 1982 and 2002. But, high valuations say nothing about the timing. In other words, once prices have gone from fairly valued to overvalued, there’s nothing to prevent them from going to obscenely valued like they did in 1929, 1937, 1966, 1968, 1973, 1987, 2000 and 2007.
So, what does tell us about the timing of when valuations matter? Market internals. When market internals turn down, while major averages are at high valuations, it’s time for investors to take note. Market internals are things like volume, advance/decline lines, 52-week highs/lows, credit spreads and momentum. Each one of those is flashing WARNING at the moment. When a price decline confirms these warnings, by breaking the 2015 lows, it will be time to take cover, if you haven’t already.
The time zone we reference on our charts is Pacific Standard Time. Therefore, the U.S. cash market opens at 6:30 AM PST and closes at 1:00 PM PST.