With enough leverage an 80 pound weakling can move the world. In the financial markets the fulcrum of leverage is the interest rate on long term treasury bonds. Forecasting the correct fulcrum rate (I call it the OUCH RATE) correctly can make you rich in a hurry and forecasting it poorly can make you poor equally as fast. What is the current OUCH RATE?
Answering the above question is akin to the question of where should the FOMC stop raising short interest rates. The problem is that the answer to the question changes every time there is a new piece of financial news! In other words the "OUCH RATE IS CONSTANTLY CHANGING"!
I call it the OUCH RATE because this is the most important rate that investors need to know. Should investors ignore or forecast it poorly, they do so at great peril to their financial health. Let me use a few numbers to illustrate the problem.
We know the Thompson forward earnings projections on the S&P 500 to be about $75.70. We know the S&P is currently trading around 1230. The forward price to earnings of the S&P is thus about 16 times. We know that historic 10 year returns on stocks when the P/E is around 16% to be between 8 and 9% compounded. The decision for long term investors is pretty easy. Good quality bonds are currently yielding less than 5% so 8 to 9% return is the best alternative.
Aggressive investors or anyone with a shorter time frame has a tougher decision to make. Flipping the P/E upside down we get the following calculation $75.70/$1230 = 6.15%. The result is the S&P forward earnings yield forecast of 6.15%.
Does this make the OUCH RATE on treasury bonds 6.15%? No!
There are too many variables to declare a yield of 6.15% guaranteed by the US Government to be superior to a projected yield of 6.15% in stocks--books and books have been written. Although we know that the bond rate must equal the inflation adjusted growth in the economy in the long run, we never really know how much of the rate is growth and how much is inflation. And, of course, our projections of earnings growth may turn out to be very wrong.
Back to the OUCH RATE. Lets presume that long rates reach 5.5%, the fed continues to tighten short rates and the S&P is still trading around 1230. Stocks are throwing off earnings of 6.15% and yet government bonds offer 5.5% guaranteed. However, the fed tightening slows the economy which in effect reduces corporate earnings and lowers the bond rate. Suppose you forecast that rates are about to return to 4.5%, a drop in long rates will cause your bonds to appreciate about 14%. This increase is in addition to the 5.5% interest yield. The total return in bonds would be better than 19% while the return on stocks would be negative by about the same magnitude.
The implied decline in earnings would be about $12.30. Even if the P/E ratio stayed the same, the drop in the S&P would be in the neighborhood of 16%.
I am a RAGING STOCK MARKET BULL. I see short term risk as the market has made a good run and sentiment has built up a head of froth but I am still a BULL. The reason is that the path for our economy seems to be pretty clear. We are growing at a relatively steady and strong rate of about 6.25% without running into resource shortages (oil being the one possible exception).
The result is that the inflation rate has been tame even with the FOMC offering money for the past few years for almost free! Now that the FOMC is taking the stance that you have to pay real money to borrow from the Fed, whiners are whining. The truth is that short rates had to go up and the evidence so far has been that the FOMC has moved up at about the right time and by about the right amounts.
Industrial capacity is available. Companies such as Dell, INTC and GLW are building new plants but most companies are meeting demand from existing facilities and labor is available. It is interesting to note that GLW pre-sold all its production at its new 1.5 Billion Dollar plant before building it.
The combination of growth and inflation will go up in the next few years. Bond yields will thus go up but the OUCH RATE is certainly well above the current rate on bonds. Indeed the total return on long bonds over the next year is likely to be negative. Should rates rise by 1% the decline in value of long bonds will be around 11%; the net will be negative 6.5%.
On the other hand, stocks will enjoy earnings growth of about 12%, while P/E ratios will likely contract a little. The total return including the current earnings yield of 6.25% will be around 15%. Fifteen percent is not chopped liver and it is certainly better than negative 6.25%. The most likely miss in my forecast would be the P/E contraction. In an emotional BULL MARKET multiples might remain at this level to boost the total return to 18.25% or they could expand taking the total return up to 20% or better.
Some folks believe the FOMC has already tightened too much. They see evidence in the low bond yields. This logic is close to a dogs tail chasing. If rates are already too low, there is less competition from bonds to fear. However, one must not rule out the possibility that the FOMC has tightened too much and the 1% decline in bond rates will be from 4.3 to 3.3%. In my opinion, the low rates are actually a forecast of very low inflation rather than slower economic growth.
BUY STOCKS--SELL LONG BONDS--SELL RESIDENTIAL RENTAL PROPERTIES--REDUCE MONEY MARKET SAVINGS ACCOUNTS TO 6 TO 12 MONTHS OF LIVING EXPENSES! BUY THE BULL!