Want To Know The Future? Look To The Past. The 1950s Are Coming Back

by: Robert Wagner

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I've written many articles about how the ending of QE called "the taper" should result in higher interest rates, and that should be good for equities. The talking heads on CNBC have also picked up on that theme, and provided a very good analogy as to why. Right now the economy is on life support, and Ben Bernanke and the Fed are administering CPR to keep the patient alive. "The taper" represents the fact that the patient has stabilized enough to be taken off life support, and can now attempt to stand on its own two feet. That is a good thing for the economy and stocks, as the increase in earnings and confidence and lowering of the risk/fear premium should outweigh the negatives of marginally higher interest rates.

The old paradigm of higher interest rates are bad for equities simply doesn't hold in this case because that paradigm is based upon historical periods where the Fed is increasing interest rates to slow the economy and deliberately reduce consumption, inflation and indirectly earnings. This situation is the exact opposite, higher interest rates won't be in response to an overheating economy, higher interest rates will be in response to the patient emerging from a coma, and is starting to regain consciousness. In this case, the patient will be likely to walk, let alone run at a speed capable of generating inflation.

The rise in interest rates should also be tempered this time because of the relatively high unemployment and excess capacity in the economy, as well as the large cash positions sitting on the sideline waiting to buy bonds once returns become attractive, or equities once confidence returns. Cash represents overhead supply for bonds, and should slow any increase in interest rates. It also represent idle buying power for equities when the time comes to take on risk.

In the above linked video it also mentions that large institutions and pensions have only 31% in equities, 10 years ago they were at 50%. Once confidence returns to these groups, they will likely sell their bonds to buy equities. That will drive rate higher, but the buying of equities should drive them higher. This is the reverse of the usual dynamic when people sell equities to buy bonds as interest rates go higher. The historical example of the 1950s was given to demonstrate how this dynamic worked in the past. During the 1950s interest rates increased from 2% to 6 or 7%, and equities still went higher. The growth in earnings outpaced the increase in interest rates, allowing equities to go higher, along with interest rates.

In conclusion, the fear being generated by "the taper" may not be justified. The dynamic between equities and bonds is likely to be more like it was in the 1950's than it was in the 1970's and on. Unlike periods where higher interest rates are being used to fight inflation and slow growth, higher interest rates this time will simply represent that the economy is returning to growth, and that should be a good thing for the economy, earnings and equities.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.