stock prices in a rising interest rate world (II)

why should stock prices decline if bond prices do?

The main argument that they should is an economic one–that demand for stocks (or bonds, for that matter) is only one expression of a more basic demand, a desire for savings.  That demand expresses itself in interest in liquid vehicles like stocks, bonds, or cash, as well as illiquid ones like real estate or hedge funds.

Allocation among investment vehicles is partly a function of individual preferences, partly one of price/expected return.  In theory, investors change their allocation among liquid alternatives like stocks, bonds and cash depending, at least to some degree, on their perception of relative value.  So, if bond prices go down (bonds become cheaper), investors will allocate more new money to bonds and will sell some of their (now relatively more expensive) stocks to buy bonds.  Professional arbitrageurs may join in, too.  This selling makes stocks go down, too.

In the real world, however, this doesn’t always happen.

Look at recent history.  Stocks are up 150% over the last four years, while individuals have shunned equities and poured money into bonds.  No judgment of relative value there.  No consideration of potential future returns.

What about the AAPL bond offering?  Only a few weeks ago, people were more than happy to buy AAPL 30-year bonds with a(n ultra-low) coupon of 3.85%, even though the Fed had been making it clear for a long time that the normal rate on cash should be higher than that.  No long-term thinking here.  Those bonds are now more than 10% lower, as sentiment has changed.

end of recession vs. end of the business cycle

When the economy is overheating and chronic inflation threatens (not the situation we’re in now), the Fed raises rates.  Bond prices drop.  Anticipating lower profits, stocks also fall.

At the end of recession, on the other hand, the Fed raises rates from emergency lows back to what it judges to be normal (inflation + a real return for lenders).  Bond prices fall.  Historically, in this situation stock prices don’t.  Historically, they go sideways to up, because the Fed’s intention is to remove emergency assistance, not to slow profit growth.

It seems to me that this is a key difference that Wall Street is overlooking so far.  I can understand why the bond market is upset, though.  I would be too if I thought that thirty years on cruise control, riding the gravy train of ever-lower interest rates, is over.

does the absolute level of interest rates matter?

Jim Paulsen’s comments that I wrote about yesterday made me think back to a simpler time–the mid-1980s.  Arguably, you have to go back that far to get a period when markets weren’t distorted by Alan Greenspan’s penchant for very loose money policy.

Back then, it seemed to me that investors looked carefully at the return they could get on a cash deposit vs. what the stock market might offer.  If money markets began to yield, say, 5%, some market participants would begin to shift money out of stocks and into cash.  The idea seemed to be that a 5%, 0r a 6%, return that was very likely over the following twelve months and that involved very little risk was preferable to a potential 8%-10% return that required taking the risk of owning stocks.

I don’t know, but it may be that the absolute yield on cash will be a more important consideration again today for stocks than their relative value vs bonds.  If so, in today’s world, a 4% yield on cash might be the threshold for switching out of stocks.  Maybe it’s 3.5%.  But it’s certainly not the current zero.

stock prices in a rising interest rate world (I)

Jim Paulsen

I’ve been a fan of Jim Paulsen of Wells Capital Management (part of Wells Fargo) for a while.  My only caution is that his thoughts and mine usually run along the same optimistic lines.  So he provides me more confirmation of my own views than a radically different viewpoint to test them against.

stocks should be okay

His latest Economic and Market Update, dated June 25th, talks about what happens to stocks when interest rates begin to rise after a recession.  He focuses on consumer confidence as the key variable to watch.  So far it’s signaling that stocks should be okay even as interest rates rise (and bond prices fall).

my thoughts

Up until now, I’ve been mostly satisfied with the argument that over the past thirty years stocks have always gone sideways to up as the Fed raises rates from recession-induced emergency lows.  Recently, though, I’ve been trying to think through what might go wrong this time.  All I can come up with is:

–the Baby Boom is older and has different investment preferences

–the road back to normal rates is an especially long one (in keeping with the severity of the Great Recession)

–market participants seem to me to be less thoughtful and more emotional (maybe the result of using cable tv as an information source).

None of these is enough to change my mind that stocks will be basically okay.  But I’ve also been looking for positive arguments that reach this conclusion–not just lack of strong reasons to be suspicious of past investor behavior in similar circumstances.

one key distinction to make…

…before we go any farther.

What we’re talking about is Fed action that brings money policy from accommodative (loose) to normal, not normal to restrictive (tight).  The difference?

–the Fed fights recession by setting short-term interest rates below the rate of inflation.  In other words, it more or less gives the money away to anyone who promises to spend it!!  It does this to simulate investment and consumption.  Ending the giveaway by moving rates back up to slightly above inflation and giving lenders a real return on their funds, is the move from loose to normal.

–on the other hand, when the economy is expanding too quickly and creating inflation, the Fed moves rates substantially higher than inflation.  Its intention is to slow economic activity back down to a sustainable rate.  That’s not what the Fed is doing now.  (In fact, it’s not even talking about stopping the giveaway.  It’s only suggesting it may slow down the rate at which it shovels the money out the door.

Paulsen’s observation

Paulsen’s main point in his June 25th strategy piece is that during periods when interest rates are rising, there’s a strong positive link between consumer confidence and stock market performance.  Historically, the S&P has advanced on average at a 12.8% annual rate during months when bond prices were falling but consumer confidence was rising.  However, when bonds were falling and confidence was dropping as well, the S&P also declined, at a 6.4% annual rate.

Paulsen cites two consumer confidence measures, the monthly Consumer Confidence Present Situation Index from the Conference Board, which has been advancing steadily since late 2011, and the daily Rasmumssen Consumer Confidence Index, which has also been rising since August 2012.  Both indices have continued to go up, despite the recent rise in Treasury bond yields.

In his strategy update, Paulsen is a little vague about what he thinks is in store for stocks.  He says, “Yes, yields are rising.  But the key is that improving confidence seems to be at the core of what is driving them higher.  If this continues, higher interest rates should not materially impact economic activity and the stock market may continue to provide favorable results.”

In a slightly earlier (June 18th) piece, Dr. Paulsen is more specific.  There, he says his guess is the S&P will move in a 1550 – 1750 range through yearend, before beginning to advance higher in 2014.

That’s providing consumer confidence continues to be strong.

More tomorrow.

the strange-but-true convertible issued by Priceline (PCLN)

the PLCN convertible note

I read about this the other day in the Financial Times.

On May 30th, PCLN filed an 8-K with the SEC in which it outlined the terms of a $1 billion convertible note it sold as a private placement under Rule 144a (meaning to sophisticated investors, i.e., people with at least $100 million under management).

The complete terms aren’t available, but the broad strokes are that it’s:

–a seven-year note

yielding 0.35% per year (just for reference, the seven-year Treasury note yielded 1.5% when the deal was struck and 2.2% now)

–each $1000 note convertible into 0.7608 PCLN shares.  Conversion parity (the price at which the holder doesn’t lose money by converting) is therefore $1315.  That’s  a 66% premium to PCLN’s price at the time of issue.

a sweet deal for PCLN

The company is using the proceeds, $979 million after fees, to buy back its own stock.  It will cost around $600 million for PCLN to retire the shares needed to redeem the convertible.  The rest is gravy.   That’s assuming, of course, that PCLN’s stock can rise above conversion parity at some point between, say, 2015 and 2020, depending on the exact terms of the note agreement.  If it does, PCLN will presumably call the note, forcing conversion.

The only worry for PCLN is that under unfavorable conditions it might have to pay the money back.  But it can hedge that risk if it wants.

Who would buy this thing?

The conversion premium, 66%, is about twice what I’d consider normal.

If we look at the issue in an admittedly old-fashioned way, it would take just over 188 years of collecting interest at the 0.35% rate to recover the conversion premium.

Q:  If you were that enthusiastic about PCLN, why not just buy the stock at 60% (!!) of what the convert would cost?

A:  because you can’t.

Two classes of buyers:

convertible funds, which generally can’t hold straight stocks.  Many times, the difference between winners and losers among convertible fund managers comes down to how they handle new issues.  It will likely be impossible to build a position in the aftermarket, so managers may figure the safer course is to guard against the possibility that PCLN spikes upward by participating in the issue.

bond managers, whose contracts with clients prohibit them from buying stocks.  Their thought process probably goes something like this:

As the Fed normalizes interest rates, all fixed income is going to decline in price.  The PCLN convert is a seven-year instrument so that feature won’t cause it to decline by much.  If some academic model (a wacky one, in my view) can show that the option value of the conversion feature makes the note worth $1,000 today, that should be another reason not to mark down the price.  Maybe PCLN’s rocketship ride can continue–maybe even to the point that it exceeds conversion value.  HOME RUN!!!

No matter what happens, other than a PCLN visit to Chapter 11, the PLCN convert has got to be better than a straight bond.

my take

Shows what a weird world Wall Street lives in today.

fixing mistakes: fast death vs. slow death

mistakes in general

One of the more important influences on my professional development was my immediate boss when I was running my first international portfolio.  I’ve written about her before.

–Her constant grillings on overnight Pacific stock prices pounded into my head the importance of observing daily price movements for the information they may contain.

–Her theory, or perhaps that of her British top-down mentor, that it takes three good stocks to offset the negative effects of a single clunker instilled in me how crucial it is to find and weed out mistakes as quickly as possible.

(An aside:  her idea was that a good stock could advance by 10% in a year, but that a bad stock would go down by a third before the average manager would smell the coffee.  I don’t think the numbers are necessarily accurate, but the sentiment is.)

Anyway,

fast death vs. slow death

Another of my boss’s favorite sayings–which has also become one of mine–is that “fast death is always preferable to slow death.”

What does it mean, you ask?

It has to do with fixing mistakes.

Suppose you have a large position in a mid-cap or small-cap stock  …one with low volume and/or a wide bid-asked spread.  You discover that business is not as good as you’d anticipated and the stock is likely to drop like a stone once more investors put two and two together.  What do you do?

Two choices:

–try to slowly trade your way out of the position, dribbling a little each day into the market (so that no one will notice you’re selling (as if you could keep this secret!).  That’s slow death.

–just shove the stock out the door, while others are still clueless.  Push the stock down 5%–10%, if need be–to unload most/all of it.  That’s fast death.  (This is the simplified version.  There’s technique involved in selling a large position, but that’s the general idea.)

Why is fast death preferable?

If the stock ends up 10% lower as your last shares get sold (and you’ve sold in equal amounts all the way down), your average price will be down 5%.  That’s not bad.

For one thing, you have the money to use to buy something else.

More important, if someone else discovers what you know and uses the fast death strategy, you’ll still have almost all your stock but the price will be 10% lower.  Even worse, the other guy will have used up a bunch of gullible buyers.  And his violent action will set alarm bells ringing that may cause any remaining potential buyers to change their minds.  Then you’re really in trouble.

People who choose slow death are delusional, in my view.  They don’t frame their situation using the fast death/slow death paradigm.  They want to pretend they haven’t made a mistake and that they therefore don’t need to act with any urgency in selling the bad stock.  In fact, they may think, maybe they don’t need to sell it at all.  They can consign it instead to the imaginary back room where bad stocks hide and can’t be seen (every portfolio has one).

why write about this?

It isn’t that we, as individual investors, encounter this every day.

What makes me think of this now is that bond investors are facing a similar situation in the overall bond market.  We know interest rates are starting to rise and that the upward movement has a very long way to go.  So losses are baked in the cake for anyone how continues to hold.  Why no fast death so far?

how much farther do US interest rates have to rise?

how much higher will rates go?

It seems to me to be hard to deny that the process of normalizing (read: raising) interest rates in the US from their emergency-low levels has begun.  The 10-year Treasury bond–the security that has the most influence over the determination of the stock market PE ratio–was yielding 1.72% in early April.  Last Friday the yield was 2.52%, a rise of 80 basis points.  The 30-year has moved up by 77 basis points over the same time span–from a yield of 2.88% to 3.65%.

Fed plans

If we look at the price of overnight money (the Fed Funds rate), which is the usual tool the Fed uses to influence interest rates, it’s still at effectively zero. This rate is completely under the Fed’s control.  The Fed says “normal” is 4% or so, and that it won’t make any move away from zero until the unemployment rate is below 7%.

The Fed has also been trying to push down longer-term interest rates, particularly the rate for mortgages, through unconventional means–buying tons of these securities in the open market.  The Fed has recently hinted that, although it will continue to do so, it may begin to purchase less than the current $85 billion a month as the economy shows further strength.  This could happen as soon as the fall.  That’s why the yields on the 10-year and the 30-year have been rising.

What’s normal for them?

three simple guideposts

1.  Look back to mid-2007, when the financial crisis was just beginning to unfold and see what rates were then.

The 10-year was yielding 5.03% at the end of June 2007; the 30-year was yielding 5.12%.

To get back to those levels, the 10-year would have to rise by another 250 basis points, the 30-year by 150 bp.

2.  Take the rule of thumb that the 10-year should provide inflation protection plus a 3% real yield.  The Fed’s inflation target is 2%, implying that in a normal economy the 10-year would yield around 5%.

3.  The Fed is going to eventually raise the rate on overnight money by 4%.  Longer-term rates will rise by less, because they fell by less when the Fed Funds rate was going down.

complicating factors…

Inflation is currently significantly below 2%, implying maybe a 4.5% 10-year yield.

Chinese buying has arguably depressed Treasury yields over the past decade or so.  Will that continue? (My answer:  probably not.)

As the Baby Boom ages, it becomes more income oriented.  That may keep rates lower.

…which may end up cancelling one another out

My experience is that the simplest models are most often the most accurate ones.  In addition, whether the ultimate 10-year yield is 4.0% (unlikely, in my view) or 4.5% or 5.0% doesn’t matter at this point.  There’s still a long way to go.

my take

I think the bond market has taken a surprisingly strong first step toward interest rate normalization.

Looking at the stock market PE, it seems to me that equities are already priced for a world where the 10-year is yielding 5%+–and have been for the past several years.

As for my portfolio, I’m waiting to see signs that the stock market is stabilizing so I can buy stocks that have been excessively pummeled during the current slide.