I remember conversations online from 2009 and 2010, in which I predicted that the ultra-low interest rates would last until early 2013 because the recovery would be sluggish and the Fed never likes to raise rates shortly before an election. I was pretty confident that rates would start going up at that point, and I never dreamed that we would now be debating whether they will go up by 2015. I have also been surprised at the low rates on 10 and 30 year Treasury bonds. Who can possibly think that these are good investments now?
It is difficult for younger people to understand how exceptional this interest rate environment seems to those of us who lived through the 1970's and early 80's and got used to double digit returns on money market funds and the assumption that mortgage rates would never return to single digits. I bought a house in 1979 and assumed the 10% mortgage; in a couple of years, the bank was offering me a large reduction in principal if I would convert to a "market" rate. One broker told me in 1982 - when yields on 30 year treasuries were approaching 20% - that it was immoral for any investment adviser to encourage his clients to purchase long term bonds. For those of us who lived through those times, what seems truly unusual today is, not the deficit, the political gridlock, the imbalance in trade, or even the threatening international picture - no, what is totally unprecedented for us is low, low, low interest rates.
What does this mean for equities? In a very fundamental sense, a common stock certificate is a piece of paper which entitles its holder to a stream of dividend payments and, in a more indirect and confusing sense, a stream of free cash flow from the enterprise. The streams extends (hopefully) far into the future and the problem is always how much those streams are worth today. Most methodologies for solving this dilemma involve a "discount rate" to be applied to the future dividends or cash flows and reduce their value depending upon how far away in the future they are. The choice of this discount rate is a complex matter, but most analysts playing with a full deck of cards would acknowledge that interest rates are relevant; there can be a furious debate about "which interest rates" and "how" they should be adjusted. But the lower the discount rate, the more the future cash flows or dividends are worth today and, as a very general matter, the lower the prevailing interest rates, the lower the discount rate. There you have it: the simplistic argument that lower interest rates should translate into higher stock prices. Not with mathematical precision or timing, and certainly not with inevitability. But with high probability, especially in the long term.
Alas, the market is cruel and fickle and does not always do what it should. I would be the first to admit that I cannot predict with any pretension of mathematical accuracy what it will do. I have always found more interesting the analysis of what is likely to happen in response to low interest rates if the market as a whole does not move up to reflect the greater present value of dividend and cash flow streams. Reviewing the past few years and looking into the future, these trends have and will become more and more dominant unless the market as a whole moves up significantly.
1. Reliable Dividend Stocks Will Trade Like Bonds - Certain stocks could be viewed as highly reliable dividend stocks. For example, the Dow Jones Utility Stocks as a group continued paying dividends without a hiccup through the Panic of 2008-09 in the aggregate and have very slowly but very reliably increased those dividends ever since. These stocks could be described as "bond-like" in the stability of their yield. In fact, I could probably select various bonds and various electric utilities and be better assured that the electric utilities would continue paying dividends than that the bonds would continue making interest payments. You can reduce your risk further by diversifying and buying a mix of utilities.
The utility stocks have had periods of above average performance and it is getting harder and harder to find utilities yielding more than 5%. The stocks are starting to trade like bonds. They are not alone. Among the stocks with long histories of increasing dividends a kind of "glass ceiling" is beginning to form around 3.5 - 4.0% and those stocks bounce off a kind of "price floor" whenever their dividend yields approach the "ceiling." Of course, this means that whenever they increase their dividends, the ceiling and the floor both move higher. This all makes sense. These dividends are attractive in comparison with available bond yields (completely ignoring the fact that dividends receive a - possibly soon to be extended - major tax advantage over interest payments).
2. Share Repurchases Will Continue to Increase - The last few years have seen ever increasing levels of share repurchases and, in some important cases, rapidly reduced share counts. Wal-Mart (WMT) and Microsoft (MSFT) have both been aggressively buying back shares, and it is not hard to figure out why. A company with a large amount of balance sheet cash can automatically increase per share earnings as long as its earnings yield (the inverse of its price earnings ratio) is less than the after tax interest rate on its balance sheet cash. For a company which is aggressively deploying that cash and earning three percent before taxes and two percent after taxes, per share earnings will increase as long as it buys its stock at prices of less than 50 times earnings.
Needless to say, there are lots of big companies trading for much, much less than 50 times earnings; there are also lots of big, big companies earnings with much, much less than 3 percent on their balance sheet cash. So the potential to increase per share earnings this way is enormous. CEOs are fully aware of the market's impatience with a failure to increase earnings and so it is not surprising that share repurchases have become popular. Indeed, a company can even borrow and - again as long as the after tax interest rate on the borrowings is less than the earnings yield - increase per share earnings this way. And finally, a company whose dividend yield is higher than its after tax earnings on its balance sheet cash can improve its after dividend cash flow by buying back shares. The fewer the number of shares, the less expensive it is to increase dividends. One way to look at this is - if stocks are cheap and bonds are expensive, big companies will sell bonds and buy stocks.
3. Refunding at Lower Interest Expense - Although it is a less important phenomenon, certain companies have and will reduce their interest expense by replacing expensive debt with lower interest rate debt. In some cases, this happens as a matter of automatic adjustment; in other cases, it must await the maturity of an existing bond issue or the "call" of an existing bond.
4. Cash for Stock Takeovers and LBOs Should Increase - A company with balance sheet cash or with financing capability can increase its earnings as long as the earnings yield on the assets or company taken over are greater than the after tax interest income on the cash used or the after tax interest expense of the debt. Again, this implies that takeovers can occur at high multiples and still be accretive to per share earnings. I have frankly been surprised that there has not been more of this activity. I was very surprised about a year ago, when Seagate Technology (STX) engineered a large takeover as a "stock for assets" deal because, in my view, STX stock has been depressed and trading at very low multiples. The company's subsequent action vindicated my view of the market when it used cash flow to repurchase all of the shares issued for the acquisition in the next quarter or so, making the deal essentially a two-step "cash for assets" deal. Still, I have been surprised that we have not seem more of this activity and I would expect it to pick up given the interest rate environment.
5. Recovery of the Financial Sector - In 2009, as the bond market improved, I tried to look for stocks which offered the opportunity to "buy debt in the equity market" and focused on Business Development Companies (BDCS) and Mortgage Real Estate Investment Trusts (MREITs) - both categories hold debt instruments as assets and make money on the "spread" between the interest rate on these instruments and the interest rate paid on borrowings. These sectors have generally done well and have even been engaging in secondary offerings over the past two years. Agency Mortgage REITs have pulled back recently but, I suspect, it has been overdone because, even though dividends have declined, we are still in double-digit territory and that is harder and harder to find.
Of course, banks do essentially the same thing that these other entities do on a bigger and generally more highly leveraged scale. The ability to pay essentially zero interest on deposits has enabled the banks to rebuild their balance sheets. At some point, bank failures will be reduced to a level which may give the banks a plausible case to reduce the rates they pay for deposit insurance(which probably are now a bigger expense for banks than the payment of interest on deposits). There will, of course, be squalls from Europe and lawsuits and ticking time bombs on the balance sheets but, as time passes, these things may be of less and less significance; the sector had a good year in 2012 and could be a force leading the market higher.
Let me conclude by making a couple of observations. I am not going to try to articulate a formula here. In the 1990's, we had the Fed Model which argued that the earnings yield on the S&P 500 should be the same as the yield on the 10 year Treasury Bond. This "Model" would suggest a PE of about 60 for the market as a whole now and no one believes that. A more reasonable model postulates that the earnings yield for a company should be the same as the after tax interest expense of marginal borrowing on the theory that, if the earnings yield is lower, the company can "optimize" its balance sheet by borrowing money and buying back stock. For a company that can borrow at 6% (producing an after tax interest expense of between 4 and 5%) , this would imply a PE of between 20 and 25. I don't really want to follow this line of reasoning because we live in a time of "leverage terror." But I also think that any methodology (such as the Tobin Q or the Shiller 10 year Trailing PE) that essentially ignores prevailing interest rates is missing something very, very important in today's market. And I think that there will be a lot of money to be made by understanding and watching the trends identified above. That's a lot of what I am going to be writing about over the next year.