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.

US bond market environment, October 2012 (II)

Here’s the second installment of the Bond Market Environment letter to clients by Denis Jamison of Strategy Asset Managers.  The first appeared yesterday.

debt without cost

Federal government borrowing has spiraled since 2008.  Total public debt outstanding–an amount that includes the notional amount owed by the Federal government to the various government trust funds–was $15.2 trillion at the end of 2011 compared with $9.2 trillion four years earlier.  Now, that debt is probably a trillion higher and exceeds nominal Gross Domestic Product.

You would think that much borrowing would put a huge strain on the federal government’s budget.

Well, it hasn’t.

In fact, for the year ended December 31, 2011, the interest payments on the federal debt were just 5% higher than in 2007, despite a 65% increase in the debt outstanding.  Moreover, the interest on the federal debt last year was just 1.5% of GDP.  That’s less than the 3%-plus drain on the country’s earnings during the second half of the Eighties and through the Nineties.

two reasons for this happy situation:

–first, the growth miracle during the Clinton Presidency provided a huge expansion in GDP while temporarily reducing the actual level of federal government debt.  And,

–second, the Federal Reserve’s zero interest rate policies begun in 2008 that reduced the interest cost of that debt from about 4.5% to less than 3%.

The trend in the cost of the federal government’s debt is glacial.  It takes a while for old bonds to mature and be replaced by new ones.  So the federal government’s debt costs will remain manageable for the next few years.  Investors should be very aware that the higher level of  federal debt to GDP plus the extraordinary low level of current interest payments could provide a severe headwind to economic growth down the road.


Bond investors have every reason to be confused.  They have enjoyed thirty years of high rates of return caused by steadily declining interest rates.  For various reasons, we experienced a secular decline in inflation since 1985.  Meanwhile, monetary policy amplified the impact of that decline on bond prices by steadily reducing the real rate of return (the nominal yield less the inflation rate).  We may have gone as far as we can down this road.  Real yields of most US Treasury securities are negative.  That’s happened before–in the Seventies.  Then it was caused by high inflation against a backdrop of loose monetary policy.  The inflation cure involved tight money, sharply higher interest rates and back-to-back recessions in the first half of the Eighties.

While Fed Chairman Bernanke draws parallels between the economic problems of the Thirties with those of today, he might want to consider the legacy of the Burns and Miller policies of the Seventies.  After the 1.5% inflation rates of the Sixties, these Fed chairmen didn’t think future inflation would be a problem, either.  And low interest rates seemed a good idea in exchange for economic growth.

It is likely bond investors will suffer a bear market someday–we just don’t know when.  For the moment, the music is still playing, so you have to keep dancing.

The only way to earn a real return today is to accept greater risk–maturity (or call) risk, credit risk, currency risk, liquidity risk and a lot of other risks that you won’t know are risks until something bad happens.  While I can’t pick the next winners (or losers), I can see a sector by sector return pattern created by the various waves of Federal Reserve policy.

By pushing short-term interest rates to zero, the Fed caused a huge rally in the US Treasury securities.  The gains now are limited because the real yield from these securities has reached zero.  Next, mortgages rallied as they were seen as a low risk alternative to government debt.  Now they, too, are exhausted because, at current price levels, prepayment losses are wiping out most of their coupon income.  That leaves maturity risk and credit risk still on the table for most investors.

maturity risk

The yield spreads between ten and thirty-year bonds are still attractive.  In the US Treasury market, that spread is about 125 basis points.  But the price risk for any change in interest rates is very high.  For example, investors in the current US Treasury thirty-year bonds would lose 15% if rates increase from the  current 3% to 3.5% ove the next six months.

credit risk

Assuming maturity risk isn’t to your liking, maybe the answer is corporate bonds.  Of course, there’s a lot of supply here because companies are busy selling new bonds to pay off old ones.  Maybe all this supply is keeping yields relatively high.  The spread between AAA-rated corporate bonds to ten-year US Treasuries is about 160 basis points.  If you can stomach BBB-rated securities, you’ll earn a 300 basis point advantage over governments.

Investors face difficult choices.  Old strategies aren’t working well in the current investment environment.  Unfortunately, when you step out on a new path, you never know where it will lead.

US bond market environment, October 2012

This is the quarterly letter sent by Strategy Asset Managers, LLC, a bond management firm, posted with permission from my friend and mentor, Denis Jamison.

Today’s post sketches out the current situation.  Tomorrow’s wil give Mr. Jamison’s investment conclusions.

a market of bonds

It’s an old saying on Wall Street–this isn’t a stock market but a market of stocks.  In other words, individual stocks can rise or fall regardless of the general direction of the market.  The same can now be said of the fixed income market.  formerly, the direction of interest rates dictated returns across most segments of the bond market.  If Treasuries called the tune and the rest of the fixed income market danced along–some a little slower or faster–but they were all moving to the same beat.

That’s now changed.

Policies implemented by the federal Reserve effectively have eliminated real yields for “riskless” securities like US Treasury bonds.  (By riskless, I mean credit risk–that is, the risk of not getting paid at maturity.  T-Bonds still have plenty of market risk.)  Without government bond yields calling the tune, all sorts of other factors are determining returns in various segments of the fixed income market.

The markets are now being driven by monetary policy designed to:

(1)  keep interest rates at zero for short-term, low-risk investment-like savings accounts and US Treasury bills and notes,

(2)  narrow the yield spread between “safe” investments like US Treasuries ans riskier investments like corporate bonds, and

(3) lower the return spread between fixed income assets and securities with no maturity–like common stocks.

In fact, the Federal Reserve would really like investors to go out and spend their money on real goods and services.  It has stated that zero interest rates are here to stay until the economy has fully recovered–that means much lower unemployment and much stronger economic growth.  Chairman Bernanke, unfortunately, doesn’t have a crystal ball and isn’t telling us when he thinks that will happen.  At the moment, however, he plans no change in interest rate policy through 2014.  Of course, he has pushed out the probable end date of his quantitative easing program before and is likely to do it again.  Market pundits have started referring to the Federal Reserve’s monetary policy as QE unlimited.

When the bank is playing…

…you just keep dancing.  We have just entered the third phase of the Federal Reserve quantitative easing.  in the wake of the 2008 financial collapse.  Essentially, “quantitative easing” means that the Federal Reserve will buy financial assets from banks and put cash in their–the bankers’–hands.  The hope is that, somehow, this money will filter through the system and the banks will loan that money to you and you will buy a house or a car or anything.

Why doesn’t the Federal Reserve just lower interest rates and make the loans cheaper?  Well, interest rates are already at zero so they need to do something else.  Since the banks are stuffed with money, will they loan the money to you?  No, because you don’t have a stellar credit history and your house is under water.  They refuse to take credit risk because they face political and regulatory retribution if they suffer any losses.

Has the quantitative easing program improved the economy?  Not yet, but it has certainly been a windfall for the financial markets.  The S&P market index is up 115% off the 2009 lows and every time it seems to be losing steam, we get another QE program.

Is all this going to end badly?  Probably, yes, but in the meantime don’t fight the Fed, don’t fight the tape and keep dancing.

The quantitative easing programs are having one clear impact–a massive increase in the Federal Reserve’s balance sheet.  The Federal Reserve was created in 1913 through a bill sponsored by two legislators, Carter Glass and Parker Willis.  Mr. Glass later went on to co-sponsor a bill that prohibited commercial banks from being securities firms.  (Interestingly, that 1933 piece of legislation was struck down during the Clinton administration.  Some say the repeal was a root cause of the 2008-2009 financial collapse.) The Federal reserve’s mandate was to provide liquidity to the banking system in times of crisis and to gradually expand the money supply to support non-inflationary economic growth.

Until 2008, the Federal Reserve provided that liquidity to the banking system by gradually expanding its assets through the purchase of government bonds from the banks.  That has changed.  Federal Reserve assets grew from $890 billion in June 2008 to $2.8 trillion most recently.  This is the result of asset purchases made by the Federal Reserve through its various QE programs.  Government bonds account for $1.6 trillion of those assets.  Another $800 billion are mortgage-backed securities and the Fed plans to add about $60 billion a month to that pile.  Unfortunately, the Federal Reserve’s capital base hasn’t kept up with the asset growth.  Now, $55 billion in capital supports those $2.8 trillion in assets–a leverage ratio of 50:1!

So, the Federal Reserve has done an excellent job of reducing leverage in the banking system through the purchase of all those assets and, as an additional benefit, helped keep government borrowing costs low.  But it has transferred a large portion of private sector bank leverage to its own balance sheet.  Any percentage change in the price of the assets on its balance sheet will be reflected fifty-fold as percentage change in the Fed’s capital.

In the movie”It’s a Wonderful Life,” the banker,George Bailey, was lucky enough to have an angel when his depositors make a run on the bank.  I hope Mr. Bernanke has an angel on his side if interest rates ever rise.


More tomorrow.

foreigners now own more Japanese government bonds than any time over the past thirty years…Why?

foreign JGB ownership continues to rise

The Bank of Japan announced last week that foreign ownership of its government bonds has now reached  the highest level since 1979.

The foreign investors piling in aren’t individuals like you and me.  They’re mostly professional bond investors who manage mutual funds and institutional pension accounts and, to a lesser extent, non-Japanese central banks.

What’s the attraction?

To the layman’s eye, there would seem to be none.  The Japanese economy hasn’t grown much for over two decades.  The Tokyo government continues to borrow heavily to run its operations, so the stock of JGBs continues to expand.  And interest rates are extremely low.

There are, however, two positives.

90% or more of Japan’s government bonds are held by Japanese citizens and institutions.  They regard JGBs as the ultimate safe investment.  They also see themselves as having little other choice (without taking unacceptably high amounts of risk) than to continue to hold.  They roll their money over into new bonds when their current bonds are redeemed, too.  So–unlike the case with, say, US Treasuries, where foreigners own about half the outstanding bonds–there’s little chance of the JGB market being roiled by panicky foreigners repatriating funds to the their home markets.

Also, the Japanese economic situation is well-known.  It has been for all practical purposes unchanged for over two decades.  Chances of any change appear to be slim.  To boot, in the deflation-prone Japanese economy, low yields look somewhat better in inflation-adjusted terms.

In other words, although you won’t make much money–other than a possible currency gain–the chances of a loss appear to be very small.  That’s what makes Japan so attractive to global bond professionals.

not so in the rest of the world

The sub-prime mortgage crisis in the US and the Greece/Italy/Spain government debt crisis in the EU have driven bond yields for Treasuries and for German governments to within striking distance of JGB yields.  In fact, short-term German government notes trade at negative yields.

Inflation-adjusted, Treasury yields are already negative, as well.  It’s possible that economic recovery now under way will eventually cause inflation to rise further, worsening this situation–and causing the Fed to raise rates.

In Germany’s case, if the Eurozone is to survive it looks like Germany will have to accept more inflation than it traditionally has been willing to do.  It will also bear a large amount of the cost of bailing out profligate Spain and Italy.  (Greece?  It’s too small to matter; my personal bet is that Athens will be eventually expelled from the EU.)

in short

Marketers of bond funds continue to tell us that bonds are a good place to have our money.  If we look at what those managers are doing with any funds we give them, however, we see the best low-risk option they’re able to find is Japan, whose virtue is that losses will probably be minimal.

Another case of:  watch what they do, not what they say.

Bond Environment, 2Q12 (ii)

This is the second installment of the current bond market outlook of Denis Jamison of Strategy Managers, LLC.  The first installment appeared yesterday.
Free money…
…at least until 2014 according to the Federal Reserve. They just about guaranteed they will maintain the current zero to 0.25% Federal Funds rate until early 2014.
When the financial crisis began to unfold in 2008, the Federal Reserve responded by flooding the monetary system with credit. Now, they have a new gambit in their efforts to push consumers and businesses toward more spending – a low interest rate guarantee. The Fed seems to be taking the role of the real estate salesperson getting you to buy a house you can’t afford by offering a temporarily low mortgage rate or the car dealer looking to reduce inventories by providing zero percent financing. As Yogi Berra said after seeing back-to-back homers by Maris and Mantle, “it’s déjà vu, all over again.” Wasn’t it the mispricing and misallocation of capital that got us here in the first place?
Excess liquidity creates bubbles either in the real economy or the financial markets. Right now, the benefits of low interest rates and surplus central bank credit have flowed to the financial markets and the big commercial banks. Market participants know the Fed is behind the curve on its interest rate policy. Based on a formula derived by Stanford University economist John Taylor, the current short-term interest rate should be 0.65%. That, however, is based on trailing core CPI of just 1.9% and the current unemployment level of 8.2%. It’s reasonable to assume that core CPI will trend higher -CPI including food and energy prices is already 2.7% – and the unemployment rate will gradually respond to 2%-plus GDP growth. If you plug 2.25% inflation and 7.5% unemployment into the professor’s formula, you come up with a Federal Funds target of 1.8%. How we get there from here is anyone’s guess. But it’s very hard to get the air out of bubbles – financial or otherwise – without a pop.
Go Straight Ahead
When you reach $5 trillion, make a sharp left. That appears to have been the roadmap for the federal government’s debt expansion. From 1970 until 2008, the outstanding debt grew about 3.5% yearly and reached about $5 trillion. (In the Fifties and early Sixties, the annual increase was less than 1 %.) Direct federal government debt is now $10.4 trillion or about 68% of nominal GDP. (This only includes public debt outstanding. It doesn’t include the $4.7 trillion of inter-government holdings – otherwise known as the Social Security Trust Fund – theoretically owed by the federal government .) With the government’s debt burden growing at 11% a year and nominal GDP expanding 4% to 5%, debt could top GDP within six years.
That’s the point of no return – the debt trap. From that point forward, the cost of funding the national debt will grow faster than the economy.
There are only two ways to escape the debt trap: budget austerity or currency devaluation. So far, our elected officials appear to be unwilling to address the first alternative – and for good reason. Most of the money is spent on folks who vote. Social Security, Medicare and Medicaid account for 44% of total outlays. The defense budget grabs another 24% and social welfare spending – mostly going to state and local governments – claims another 12%. That’s 80% of the total. (Meanwhile, the small 6% slice going to pay the interest on the national debt will likely balloon over the next few years.) Devaluation is tricky – but much more doable. If inflation can be pushed higher, the nominal value of everything real goes up and the actual value of debt goes down. It’s worth remembering from 1974 through 1981, nominal GDP grew at a 10% annual rate despite two recessions. Little of this growth was real – inflation adjusted GDP averaged just above 2% a year –but it sure lowered everyone’s debt burden.  In that regard, it’s worth citing a quote from Adam Smith, “All money is a matter of belief.”
Keeping a Low Profile
We continue to keep the effective maturity of our clients portfolio’s below that of their benchmarks. This served us well during the March quarter and the accounts tended to outperform their benchmarks. It is worth noting, however, that a bearish stance in a bear market does not necessarily mean you make money. Good relative performance does not mean good absolute performance. During 2011, long-term U.S. Treasury bonds returned nearly 30% and the mortgage market recorded an 8% gain. We expect most of those outsized increases to be reversed this year. Given the low absolute level of coupon income for most bonds, even a small increase in interest rates will translate into a negative total return. The current year promises to be quite difficult for most bond investors.