Thoughts on rates

Stocks A to Z
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A) My greatest concern is the federal deficit? It looks like the federal government bring in $4 Trillion per year. The deficit is $30 Trillion. So if the whole deficit reprices to current rates levels, that would imply $1 Trillion or 25% of our federal budget would be for interest payments.

B) Current and projected fed fund rates are still no higher than 4.5%. From 1960 to 2000 fed funds Prior to 2000, Fed funds only briefly (1992 - 1994) traded below 4%.

During the 1990’s the S&P 500 P/E ratios never traded below 15. Trading well into the 20’s at times.

Based on the current 30 year treasury rate of 3.52%, the implied P/E of a government bond with no growth for 30 years is still 28.41.

I did some basic modeling. Take MSFT for example.

Current price $244. Earnings of $10.25 ish. Implied P/E of 23.8.
If MSFT grow earnings at 11% per year for 5 years then the P/E ratio drops to 15.8, while the bond still has the same implied P/E.

It does appear that companies with long runways of profitable growth exceeding GDP, should command a P/E of 25+. Of course history is littered with growth stories that flopped. Lucent, Digital Equipment, compaq, etc. But until a company is disrupted it looked like a good bet to hold on.

In the 80’s fed funds traded well above 8% and traded between 5 & 6% for most of the 90’s. It is plausible that we are just returning to more normalized rates. Mortgages of 5 - 7%, P/E’s 15 to 20.

Of course some businesses that rely on lots of debt, may find margins squeezed as they have to refinance (Government is the most exposed), or repriced down like real estate. But strong cashflow should be much less impacted.

I would argue that banks should benefit greatly from higher rates. Their branch system was valueless in the lower rate environment. At current levels, banks are still paying close to zero for savings and CD rates at the branch level. NIM’s will soar. In the past WFC had a NIM over 4%. An extra 100 basis point or more on a $2 trillion balance sheet is huge! $16 BB after tax. $1 per quarter.

JPM indicated at their investment day earlier this year, absent a deterioration in credit that there ROE could top 17% this year. Rates are clearly higher already from that point in time.

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FWIW.

BAC has a great slide in their recent quarterly presentation.

From 2009 to 2022. Loans and leases have remained flat over that span.

However.

Credit cards down to $84 BB from $161 BB
Home Equity down from $154 BB to 27 BB
RE loans flattish. From $69 BB to $64 BB. However construction down from 39% of RE loans to 13%.

Top tier banks are much smarter this time.

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I pulled up WFC.

They have even lower levels of credit card and 2nd mortgage loans on their books than BAC. About half the level of BAC.

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During the 1990’s the S&P 500 P/E ratios never traded below 15. Trading well into the 20’s at times.
…
Based on the current 30 year treasury rate of 3.52%, the implied P/E of a government bond with no growth for 30 years is still 28.41.

You can’t compare the P/E of equities to the P/E of bonds. Sorry.
It’s like comparing apples and iPhones.

First and foremost, bond yields are in nominal returns. (TIPS are a different conversation)
But to a very close approximation, equity earnings are inflation adjusted.
Consider: if all wages, inputs, and sales prices go up by 30%, then so will profits.
The main residual effects of inflation on the real earnings equities are–

  • Some firms get hit more than others, and at slightly different times, though it’s a wash overall.
  • The rule of thumb doesn’t apply if inflation is so high the economy breaks. We’re not there, so don’t worry.

So, if inflation is (say) 6%, then even a bond paying 8% is most closely equivalent to a stock at a P/E of 50.
i.e., very very expensive and probably offering very little in the way of real return.

Plus, of course, bonds have no internal rate of return on retained earnings.
What you see is what you get.
For the average equity, the earnings per share not only keep up with inflation, but rise a little in real terms over time.

For more geeky stuff on debunking this popular misconception, one of my all time favourite papers is “Fight the Fed Model” from 2003.
https://www.aqr.com/Insights/Research/Journal-Article/Fight-…

Note, a lot of US equities are certainly very expensive on many metrics.
But that is still nowhere near enough to make bonds look like a viable alternative.

Jim

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You can’t compare the P/E of equities to the P/E of bonds

I think you can, for a very simple reason: Because this is how people actually do compare them and decide what’s the more profitable investment. If the nominal P/E of bonds is higher seen this way, they therefore buy bonds, not stocks. If that’s right or wrong doesn’t influence the decision and the effects of it on the bond and stock market.

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I think you can, for a very simple reason: Because this is how people actually do compare them and
decide what’s the more profitable investment. If the nominal P/E of bonds is higher seen this way,
they therefore buy bonds, not stocks. If that’s right or wrong doesn’t influence the decision and the
effects of it on the bond and stock market.

Well, yes, there are people who do it. And their activities no doubt make prices move. No argument.

My point was merely that, as the OP was seemingly attempting, the comparison makes no rational sense when choosing an investment.

And, most emphatically, changes in the price of bonds may change the price of equities and their relative attractiveness for fresh capital allocation, but not their value.
The value of a stock lies in its future stream of real earnings, which is unaffected by changes in the current prices of hamburgers or bonds.
The value of something is what you get. If what you get doesn’t change, the value hasn’t changed.

Jim

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Mungofitch: You can’t compare the P/E of equities to the P/E of bonds. Sorry.
It’s like comparing apples and iPhones…First and foremost, bond yields are in nominal returns. (TIPS are a different conversation) But to a very close approximation, equity earnings are inflation adjusted.

Buffett: It is no longer a secret that stocks, like bonds, do poorly in an inflationary environment. We have been in such an environment for most of the past decade, and it has indeed been a time of troubles for stocks. But the reasons for the stock market’s problems in this period are still imperfectly understood…
There is no mystery at all about the problems of bondholders of in an era of inflation…
It was long assumed that stocks were something else. For many years, the conventional wisdom insisted that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities. These, investors believed, would retain their value in real terms; let the politicians print money as they might.
And why didn’t it turn out that way? The main reason, I believe, is that stocks, in economic substance, are really very similar to bonds.
I know that this belief will seem eccentric to many investors. They will immediately observe that the return on a bond (the coupon?) is fixed, while the return on an equity investment (the company’s earnings) can vary substantially from one year to another. True enough. But anyone who examines the aggregate that have been earned by companies during the postwar years will discover something extraordinary: The returns on equity have in fact not varied much at all. (from How Inflation Swindles The Equity Investor)

Clearly completely opposed viewpoints. Is one right and one wrong? If so, who? Have the fundamentals of the business world changed greatly and permanently since the 70’s when Buffett penned that analysis? If so, how has it changed? Why should we assume the long-term future is more like now rather than the 70’s?

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Many MEGA Cap Co’s with super low capital intensity, think Google, that never existed in the '70s.

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Clearly completely opposed viewpoints. Is one right and one wrong? If so, who?

Simple: If you ask me, I’m right, he’s wrong : )
I know he’s a god, but in principle gods can make mistakes too~~
That’s my story, anyway.

Reasons?
It was written in 1977 and nobody had a clear idea of what would happen to company results over time in a modern economy with different inflation regimes.
The economy was broken at that time.
And partly it’s because a lot of what he wrote in that essay is just unfortunately phrased.

Once upon a time, inflation got so high the economy broke to a meaningful extent.
There was almost no progress in aggregate real corporate earnings from about 1975 to 1982, give or take.
Double digit inflation rates were not good for businesses, no doubt about it.
(the earnings didn’t disappear, they just stopped growing for a while)

But outside the core “broken” stretch, the data suggest that in aggregate, real US corporate earnings mostly chug ahead through lower inflation and higher inflation.

Consider:
The basic hypothesis is that when inflation (and interest rates) are high, equities are worth less.
If they’re truly worth less, then medium to long term returns would be lower.
But it ain’t so: holding starting valuation levels constant, the forward returns on equities do not correlate with the interest rate or inflation regime.
The forward returns DO vary, extremely strongly, with the valuation level at purchase date based on trend earnings.

Higher interest rates will frequently lead to lower equity prices, for sure, and that’s often at a time of high inflation.
But as we all know, the price of something isn’t the same as its value.
The value is what you get from it…the future stream of real earnings, which is essentially unaltered based on the inflation rate when you buy, or even during your holding period.
Some firms will do better or worse with higher or lower inflation, but for the “average” firm it’s mostly a wash.

The quote you mention includes:
"For many years, the conventional wisdom insisted that stocks were a hedge against inflation.
The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are,
but represent ownership of companies with productive facilities. These, investors believed, would
retain their value in real terms"

This conventional wisdom thesis, which he disagrees with, is in fact correct based on observations.
Equity prices might be quite a bit lower in a high-inflation (high-interest rate) regime,
so equities aren’t a hedge against inflation if what you’re looking at is your portfolio statement.
But they’re a remarkably fine hedge against a loss of intrinsic value. You need patience.

A sideways way of thinking about it:
Why did Mr Buffett’s investments from the early 1980s do so darned well?
Because they were so darned cheap relative to their earning power.
Why was that opportunity available?
Because the real earning power prospects held up fine in the inflationary stretch ending then. Only the prices were hit, not the values.

Jim

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Some historical data on stocks vs bonds.

A $5,000 investment over 85 years (1926 to 2011): data provided by Ibottson

  • Treasuries averaged 3.6% your investment grows to $101,053
  • Corporate bonds averaged 6.1% your investment grows to $766,968
  • Stocks averaged 9.8% your investment grows to $14,130,870

According to Stocks for the Long Run

  • Every rolling five-year investing period since 1802 (1802-1807, 1803-1808…etc.), stocks outperformed bonds 80% of the time.
  • Stocks beat bonds 90% of the rolling 10-year periods, essentially 100% of rolling 30-year periods.
  • For holding periods of 17 years or more, stocks have always beaten inflation, a claim bonds can’t make.

Lets look at a more recent time period.

1980-2013 (34 years)

Bonds (Barclay’s)

  • Years positive 31 out of 34
  • Lowest return -2.92%, 1994
  • Highest return 32.65%, 1982

Stocks (S & P 500)

  • Years positive 28 out of 34
  • Lowest return -37.0%, 2008
  • Highest return 37.58%, 1995

If you did a 50/50 split between bonds and stocks

  • Positive in 30 of 34 years
  • Lowest return -15.88%, 2008
  • Average annual gain 11.17% (gave up about 20% of stock only returns)

I’ll leave it up to you to draw your own conclusions. But, your investment time horizon certainly matters, along with your stomach for the downside of volatility, when constructing a portfolio.

Best,

Buck
TMFBuck

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Regarding inflation, yields and stock returns I might be willing to bet a box of See’s candy that 5-year TIPS yielding inflation plus 1.26% will outperform the S&P 500 over the next five years, as well as outperform 5-year treasury notes yielding 3.75%. Waiting in 12-month T-Bills yielding 4% until the stock market appears to have bottomed and then switching to an S&P 500 index might do even better. What would be your bet?

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Some historical data on stocks vs bonds. …

Good info, but—
The problem with those tables is that, though I presume they are correct, they describe outcomes in situations which do not faintly resemble the current one.

By far the biggest input into what an asset will return is not the statistically most common past outcome, but how expensive it was when you bought it.
i.e., the best estimate of the forward real yield.

At the average date in those tables, pricing was wildly different from today’s situation.
Thus the forward outcome that you should expect is wildly different.
As an example, if you buy a bond with a negative real yield you definitely won’t get a positive real return.
You probably don’t know how negative it will be until you know what inflation comes out at, but you can guess.
On the median date since 1926 the yield on long US bonds was 1.79% more than the trailing-year known inflation rate.
At the moment the long bond yield is 5.3% lower than the trailing year inflation rate, 7.09% lower than the historically typical level.
It would not be sensible to expect anything resembling the historically typical forward return outcome.

At the moment we’re drawing a random card from the deck, but the deck in question has had almost all the face cards removed.

Jim

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Some historical data on stocks vs bonds.

1980-2013 (34 years)

Bonds (Barclay’s)
* Years positive 31 out of 34
* Lowest return -2.92%, 1994
* Highest return 32.65%, 1982

Stocks (S & P 500)
* Years positive 28 out of 34
* Lowest return -37.0%, 2008
* Highest return 37.58%, 1995

If you did a 50/50 split between bonds and stocks
* Positive in 30 of 34 years
* Lowest return -15.88%, 2008
* Average annual gain 11.17% (gave up about 20% of stock only returns)

And in addition to Jim’s astute comments, the period here was a raging bull market in Bonds. That Bond Bull market is definitely over. Which makes the comparison to what we might expect in the future even more apples and oranges.

Tails