A long time ago in the 1990's, there was a popular metric for determining whether or not the stock market was over or under valued. Called the "Fed Model," it compared earnings yield (the inverse of the price earnings ratio) with the yield on 10 year Treasuries under the assumption that the two yields should be roughly equal. For some investors, the metric became almost talismanic and some pundits would argue that failures of banks and S&Ls were bullish for the market because these failures meant that the Fed had to keep rates low for a longer period of time ("Bad news is good news"). I never bought into the Fed Model to that extent but I thought it had some merit. It is interesting to apply the Fed Model to today's market and see where it takes us. Using a 3.2 percent yield on 10 year Treasuries, this metric would produce a price earnings ratio of 31 and using $879 as trailing Dow 30 earnings, we get to a Dow priced at 27,249.
It is interesting to note that you almost never hear anyone refer to this metric any more; I think that the reason is that it produces a result that no one really believes to be plausible. However, the fact that a metric widely employed in the last Bull Market is almost never cited may belie assertions that this market is somehow inflated with false optimism.
Extraordinarily low interest rates do have implications for the market. When the low rates were first implemented by the Fed, many investors may have assumed that the phenomenon would be short lived and that it could not effect long term investment decisions. However, short treasury rates have been stuck at zero for a while, bank deposits barely pay enough to finance the fuel necessary to travel to a bank branch(and you certainly cannot afford to park at a meter), and money market funds are producing infinitesimal returns. With a relatively sluggish recovery, there is really no end in sight. I have predicted no rate increase until early 2013 and I may well be wrong. But we won't go over 1 percent for quite a while.
Because stock certificates are pieces of paper that, in some cases, entitle the holder to receive periodic dividend payments and, in all cases, represent shares of enterprises which are expected to produce free cash flow, it is not unreasonable to compare them with other pieces of paper that entitle the holder to receive a stream of payments. The discounted cash flow method for valuing businesses and equities employs a discount rate which is affected by prevailing interest rates. Some economists have argued that interest rates are irrelevant because low rates imply that expected growth of nominal cash flow will also be low and so the lower level of growth balances the lower discount rate applied to the expected future cash flow. I think that, while this may have some merit, it is implausible given the fact that many enterprises earn substantial amounts of revenue outside the United States. While the low interest rates engineered by the Fed may imply low expectations for growth in nominal GDP in the United States, they really provide no information about the expected dollar denominated growth of foreign economies.
At any rate, there are a number of arguments that interest rates are relevant to stock valuations and there are a number of mechanisms for closing the gap between earnings yields and bond yields. I think that a review of these suggests some specific strategies for capitalizing on what is in many ways an extraordinary situation.
1. Dividend Yields versus Bond Yields - Ultra low interest rates make dividend stocks extremely attractive to investors; in many cases, an investor can earn an immediately higher yield on a stock than on bonds and stocks which have a history of raising dividends promise still higher yields in the future. Dividends may tend to put a kind of floor under the price of some stocks - a dividend yield of 2.5-3% may begin to represent s fair value for a solid company with no unusual warts or pimples. Of course, this means that every time the dividend is increased(for many companies, once a year like clockwork), the stock is likely to move up as well to maintain the dividend yield at the same percentage. There has definitely been a marked tendency of major companies to raise, rather than reduce, dividends and this alone may tend to push averages higher.
2. Share repurchases - Low interest rates reduce the opportunity cost of capital for many companies. In some cases, balance sheet cash is earning a very low return. In other cases, borrowing opportunities at ridiculously low rates open up. As long as a company has an earnings yield that is greater than the after tax interest expense of borrowing, it will tend to increase per share earnings by borrowing and buying back shares. Companies like Microsoft (NASDAQ:MSFT) and Philip Morris International (NYSE:PM) seem to be able to borrow at after tax interest costs of 2 to 3 percent which means that as long as the stock is trading below of PE of 33, repurchases will increase per share earnings. Of course, repurchases also reduce the amount of stock available in the market which also tends to push prices up.
3. Lower borrowing costs - Lower interest rates have now clearly been extended to corporate debt of virtually all ratings and junk bonds are being issued at reasonably low spreads. Some companies can immediately cut expenses by borrowing and using the proceeds to repay old, higher interest rate debt.
4. Acquisitions - Once again, the opportunity cost of capital is very low for many companies. A company which has balance sheet cash earning 1% interest will increase its earnings if it goes out and acquires an enterprise at a PE of 50(an earnings yield of 2%) even if there is no expectation of growth or synergy. Cash for stock acquisitions remove stock from the market, can increase the earnings per share of the acquiring company, and lead to speculation among investors in an effort to anticipate the next acquisition.
5. Dollar Devaluation - Low rates will tend to push the dollar lower against currencies of countries with higher interest rates. This process is uneven and there will certainly be periods of time in which the dollar appreciates against certain currencies. But the general direction seems pretty clear. When the dollar goes down, the foreign earnings of multinational firms automatically increase in dollar denominated terms. In addition, United States operations facing foreign competition and exporters also benefit from a weaker dollar.
6. Cash flow versus earnings - A period of sluggish growth and low inflation may also tend to increase cash flow in relation to earnings because capex will be low: depreciation may tend to be relatively high compared to capex because new capacity is not priced higher in nominal dollars than the old capacity being depreciated.
So, does this mean we are on our way to 27,000? I don't think so but I also believe that any metric which ignores current interest rates (such as the Tobin Q and the 10 year Trailing PE) are missing a very important factor for equity valuation. I also believe that, if there continues to be a wide gap between bond yields and earnings yields, many of the activities described above (borrowing at low rates to fund repurchases, acquisitions, refinancing debt at lower interest rates) will intensify. Sooner or later, the banks will use the virtually costless deposits that low interest rates have given them to loan money to individuals and businesses. If they keep rates for these loans high, they will make a boat load of money. If they compete with one another and lower rates on consumer and business loans, the economy will start to take off.
The strategies suggested by this analysis are fairly obvious:
- Recession resistant large cap reliable dividend paying stocks with international exposure to economies that are growing faster than ours are almost certainly better investments here than Treasuries - I like Proctor&Gamble (NYSE:PG), Johnson&Johnson (NYSE:JNJ), Exxon (NYSE:XOM), Philip Morris International, CocaCola (NYSE:KO) and McDonalds (NYSE:MCD);
- Companies that are repurchasing shares without creating leverage problems should create an earnings tailwind - in this category I place the much maligned Microsoft and WalMart (NYSE:WMT);
- HIgher yielding stocks like Verizon (NYSE:VZ) and AT&T (NYSE:T) can be attractive but there should be careful scrutiny to be sure the yields are sustainable (in these two cases, I am convinced they are);
- There are all sorts of opportunities to buy debt instruments in the equity market because the equity market is depressed in comparison with the market for debt instruments - these include business development companies selling for less than book value like American Capital (NASDAQ:ACAS), agency mortgage REITS providing yields in the teens like Annaly (NYSE:NLY) and commercial mortgage REITS like NorthStar (NYSE:NRF) trading below book value.
We have learned that all sorts of things can happen in the short run in the stock market. I am convinced that there will be some nasty corrections. There is also the chance that the United States will commit economic suicide by refusing to increase the debt limit, that the euro-zone will implode, or that oil flows from the Middle East will be more seriously interrupted. But on the other side of the ledger there is the risk that this period of low interest rates will see significant appreciation in equity markets and that ten years from now investors who missed the bump will still be trying to catch up. If the Fed waits to raise rates until the economy experiences a robust recovery, then the gap between bond yields and earnings yields may become unsustainable as earnings keep increasing and stocks may begin to take off. If investors wait until interest rates increase in response to this recovery, they may be too late for the party.