Zero Interest Rate Policy (ZIRP) is where the central bank maintains a policy of artificially low interest rates. Interest rates may not be "zero" but the idea is that they are "nominally" zero or less when inflation is considered. Essentially, we have been in a ZIRP environment for some time. There is no historical precedent for this environment over any significant period of time.
There is an equation, ER= I +E that can be adapted to many investment theories. ER is "expected return". I is "interest" and E is "equity return from dividends and capital appreciation".
When discussing portfolio investment allocation, one could think in terms of the "expected return" being the sum of the return from Interest on fixed income investments (bonds) plus the return from dividends and capital appreciation applicable to equities or stocks.
Another use of the equation is the attempt to explain the "expected return" and valuation of a particular investment, such as equities or stocks in general. The "expected return" from owning equities or stocks would be the return you would get from a zero risk investment, plus the "extra" return or "risk premium" that you would earn because of the special additional risk associated with stocks. Stocks are generally considered to be more risky than bonds and hence investors expect a higher return.
Generally, in either use of the equation, I is not zero. But, in a ZIRP environment, it IS zero, creating some strange and unusual outcomes as well as a great deal of misunderstanding.
In the allocation example, with I=0, ER=E, meaning the entire return from the portfolio comes from equities. In the valuation example with I=0, ER=E meaning the expected return of the investment is equal to the "equity risk premium" associated with owning stocks.
History teaches us that the "equity risk premium", or ERP, for stocks varies depending on many factors, but generally is in the range of 5% to 8% for the "market". What that means is that the price of the "market" or for an "average" stock is based on the expectation that the owner will earn an average ERP of 6.5% per year over and above the % return per year for a "riskless" interest bearing investment.
So let's say for example, we have US 10 year Treasuries (theoretically riskless in normal times) paying 5% and the ERP of 6.5%. Then the ER or expected return would be 11.5% per year. (This happens to be the average return from the stock market since 1900.)
Now, let's say that US 10 year Treasuries are only paying 2.5%. One would expect the ERP to stay at 6.5% and the ER would drop to 2.5+ 6.5=9%. But, what if people are concerned about rising interest rates, where US 10 year Treasuries could fall in value. The "riskless" interest bearing asset now becomes very short term notes that earn essentially zero interest. In this odd case, the ER would drop to 0+6.5=6.5%.
So why would stock markets rise more than 9% per year in an environment where the long term "expected return" would be somewhere between 6.5% and 9% per year? The S&P500 rose significantly more than this in 2013 and so far in 2014.
When the alternative is 2.5% from US 10 year Treasuries, then one is paying a price of $100 for a $2.50 return or a 40 "P/E" or price/earnings ratio. In such a world, to some a price of $2000 for stocks that earn $100 seems like a reasonable "P/E" of only 20. (This is about where we are right now.)
During that time from 1900 to 2014, when the market earned an average of 11.5%, the P/E averaged around 15. When market prices rise to a P/E of 20, the price for a dollar of return is theoretically 30% higher than average. Put another way, the return going forward based on current prices, on a percentage basis should be expected to be 30% less - more like 8% than 11.5%.
So, no matter how you slice and dice, the reality is that a ZIRP, while providing a temporary rise in prices, essentially reduces the expected future returns from saving and investing.
Here is the most important point…
What if ZIRP is temporary and that "magic" formula of ER=11.5% with I equal to 5% and ER equal to 6.5% becomes the norm again? That means a P/E of around 15 and a dramatic drop in stock prices - even assuming that earnings and the economy remain strong.
So unless you are one who believes that interest rates will stay below their historical averages for the foreseeable future, you should assume that the S&P500 is considerably overvalued - even if earnings grow at the same time that interest rates rise. That means that you should at least maintain a conservative asset allocation with a considerable portion allocated to fixed income. And, a portion of that fixed income should be liquid enough to take advantage of lower stock prices when they "correct" back to more normal valuations.
This should not be considered as some form of market timing strategy because when and even if this "correction" might occur is "unknowable". It is better to think in terms of the proven concept of rebalancing; recognizing that markets fluctuate between being overvalued and undervalued. Buying during periods of undervaluation is one of the keys to being a successful investor.
An important caution…Interest bearing fixed income investments in a ZIRP environment can be very risky. Bonds historically are a part of the portfolio in order to provide a stable if not even a negatively correlated return compared to stocks. But in a transition out of a ZIRP to a normal environment, BOTH stocks and many bonds will decline in value. In such a situation, investments that are stable in a rising interest rate environment may be quite attractive and valuable.
Finally, when thinking about government sponsored ZIRP, it is true that ZIRP favors the consumer over the investor. And, since consumers and borrowers as voters outnumber investors and savers, one should be aware that ZIRP will be politically acceptable until rising prices and inflation become an issue to consumers and borrowers.
I happen to believe that one major reason we have not seen inflation, despite central bank stimulus, is the simultaneous trend to force or "encourage" banks to raise capital and reduce leverage. When banks have reached the politically acceptable level of capitalization, money velocity and inflation will likely increase considerably. When this will occur is a bit of a mystery, even to the central bankers. But when it does ZIRP will end.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.