An Old School Look At The Zero Interest Rate, And Its Influence On Stock Investing

by: Stanley Barton

In the 1960s, I was introduced to economics, and other things. I recall being surprised when the professor said a bank should have $20 dollars of capital for every $100 of loans on its books. Being "wet behind the ears", I was amazed that the bank was allowed to loan money it did not have in its vaults. I now read that Citigroup Inc. (C) failed its "stress test" by not maintaining a 5% ratio.

One thing I have noticed dealing with the capital markets is that you learn little-by-little to justify things. In fact, I have been trying to figure out the stock market for so long, I now can justify almost anything. I am sure there is a way to give a passing grade to a bank that has $5 in the vault for every $100 it loans, but as a stock picker, I am not buying it.

I may be stuck in the 1960s, but this article will leap back in time before the justifications became paradigms, and we will try to define what the concept of "zero interest" means to a stock investor.

Learning experience

I learned from that wise professor that the interest charged on a loan should equal the loan expenses, plus the inflation rate plus a profit. So without getting complicated, if the service costs are 0.25%, inflation is 2.75%, and profit is 3%, then the interest rate is 6%. So "zero interest" loans seem like something that my college room-mate might have invented in a "purple haze".

Some of the smarter guys and gals in my class became investment bankers and bond traders. I guess I spent too much time with Jose Cuervo and lemons and salt shakers lifted from the university cafeteria... I became a stock picker. I did learn one thing about bonds: when the interest rate goes up, the price of the bond goes down.

I ponder why my investment banker alums are buying essentially zero-interest bonds. The government's 10-year note pays 2% and the same government targets inflation at 2%... a zero return. It seems to me, if you start at zero, the only thing that can happen is the rate will eventually rise and the value will drop. As a stock picker, I do know a thing or two about investments dropping in price. I just don't like to invest in something that has absolutely no upside and who-knows-how-much downside.

Some stocks take on the characteristics of bonds, in that their dividend yield is mostly related to the going rate for bond investments. When bond interest rates rise, their yields do too, mostly by the stock price dropping. Utility stocks are notorious for this, and I am avoiding those for that reason.

It's not nice to fool Mother Nature

In Eco 101, I was told that the capital market system was a perfect representation of the basic supply/demand dynamics of human nature. As changes occur, the markets adjust and repair themselves, and interference in this process only delays the inevitable.

The Federal Reserve has been manipulating the markets with artificial interest rates for decades. Our bankers seem too weak to ride the real bronco, so the Fed has castrated and hobbled it for them. One day the market is going to react to this in an effort to find its natural course. I do not know what that reaction will be, but I do not want to be in Financial stocks when that happens.

I want a robust company that has looked business realities in the eye and taken its best shot. Maybe it got thrown a few times, dusted itself off and got back to business, wiser for the experience. Survivors like Corning (NYSE:GLW), Kroger (NYSE:KR), and Honeywell (NYSE:HON) have been able to subtly reinvent themselves to adapt to changing realities.

All show and no go

Part of the fanfare around an artificially low interest rate is that it would stimulate housing. Since mortgage rates are at a generation-low level, one would think the stimulus would have kicked in. When I was young and raising a family, the ultimate timing of each house purchase was based on two "fear" factors: fear of losing the "dream home" to another buyer, and fear of rising interest rates.

I was on the radio in July 2011 declaring that the housing market was near a bottom. My rationale was, first, that Case Schiller was reporting that about 80% of the US metropolitan areas had experienced house price increases; and, second, that the pent-up demand was going to move in once the interest rates started to move up. The next day the Fed announced that it was going to keep the Fed fund rate near zero until mid-2013. Everything unraveled for the housing recovery after that.

The Fed had removed one of the major incentives to buy: the fear of rising interest rates. All the prospective buyers now had another two years to think about it without any risk of rising rates. Goodbye homebuilder stocks... hello Home Depot (NYSE:HD).

One of the weakest sectors in the nation's unemployment is the construction industry, and specifically house construction. I know I am arguing against the accepted paradigm that low rates encourage the housing market, but I think that the decision to artificially maintain those has hurt the current housing situation.

If it feels good, do it

Another reason for the low interest rates is to plow easy money into the economy to ultimately allow the consumers to feel free to go on a spending orgy. Working with stock investors, I have noticed that the ones that have some safety net, or rainy-day fund, are more likely to throw caution to the wind. As long as there are other concerns about their future, consumers are not going to start spending discretionary income just because of interest rates.

If consumers are like investors, they are likely to spend when they feel comfortable with their nest egg. The biggest part of the nest egg for most families is their US Social Security fund. If the Fed and lawmakers wanted to stimulate the consumer, they should at least recognize that the social security system is key to his sentiment, and do something to give the consumer the confidence that it will be there for him. From an old-school perspective, that would stimulate spending.

Even eliminating a single tax loophole, and applying the savings to shore up the social security system would send a message to consumers that might ignite the spending spree. For instance, even Tea Party members should not object to eliminating the "ex-pat tax exclusion" of about $90,000 of income for each of the workers that Ford (NYSE:F) sends to Chihuahua, Mexico to teach Mexicans how to make the cars. The amount to go to the Social Security system would probably be insignificant in the big picture, but it would be a single sensible step that might improve confidence in that system, while deterring job exportation. The point here is that the energy put into the legislation and management of interest rates can be used more effectively elsewhere.

Up against the wall

Pension funds have monthly payment obligations, and I learned that the goal was to earn a little more in investments than the fund had to pay. While the reduction of interest rates surely caused an increase in the value of their bond holdings, the replacement ones they are buying may not meet the payment obligations in the future. Over a short term, these price fluctuations can balance out, but when the rate is fixed near zero for years, a new strategy must be undertaken. I am not sure what the effect of zero interest rates are on the Pension Funds long term, but if I were a manager, I think I would be "slippin' on my boogie shoes" and dancing out the door.

Dividend paying stocks like utilities may be attractive short-term, but I have to think that the pension funds should be looking at dividend payers in the Natural Resource segment: Marathon (NYSE:MRO), Seadrill (NYSE:SDRL), and Freeport-McMoRan Copper & Gold (NYSE:FCX) come to mind. Those global stocks should be producing consistent profits over years, despite any financial manipulation from Washington.

Some institutions have restrictions against buying bonds that have a "junk" rating, although those are the ones that provide an adequate return. Some "business development" companies are NYSE-listed and they have portfolios of edgy loans to small businesses; therefore, they pay big dividends. The legitimate prospects for most of their little portfolio companies are pretty good, and the managers of these lenders are nimble at navigating interest rate trends. I think that some of the institutions that are not able to participate directly in the junk bond market may be looking at these stocks as alternatives. Ares Capital (NASDAQ:ARCC), and Prospect Capital (NASDAQ:PSEC) are two that I have owned for both the income and capital appreciation potential.

I have been to the top of the mountain

I do not want to be blasphemous, but I share Dr. King's optimism. The Stock Pickers Hall of Fame is an empty room, but each of us has to take a stand somewhere. My position is that we will get through all this "voodoo economics" like we usually do. Churchill said that "Americans always do the right thing, after they have tried everything else." I fear there will be some pain for the bondholders, but... hey I'm a stock picker. A portfolio of the nine stocks featured in this article would provide a 4.7% yield, and it would be somewhat insulated from the ultimate effects of interest rate manipulation.

I realize that I may be cruisin' for a bruisin' by detractors that I am stuck in the 1960s. I am the first to admit that the "old-school" had trouble keepin' it real, but I think the economy may be feeling the funk from zero interest rates.

Disclosure: I am long ARCC.

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