Yesterday we were on our way home from a short family vacation when my wife looked over and informed me that the headline she had just received from the Wall Street Journal was, “Surging Yields Raise Threat of Tipping Point for Stocks.” I laughed.
If you are like my wife and you don’t understand why I thought this headline was funny, let me break it down for you. The first line of that story was, “Yields on long-term U.S. government debt moved abruptly higher last week, calling into question the durability of the more than nine-year-old bull market for stocks.”
First, rising interest rates do not kill bull markets; they actually go hand-in-hand with bull markets. I know this is counter to what you have learned from every financial media outlet and the short-term traders who often sit at their desks, but it is true. In fact, it is “textbook,” as they say.
If you wish to get full credit on the relationship with interest rates and stocks on your Level III Charter Financial Analyst (CFA) exam, you had better understand this fact. Let me make it simple: when confused, always go back to the basics. What is stock? On a daily basis it is easy to fall into the trap that stocks are just digital notations (formerly pieces of paper) that are randomly traded back and forth, but that isn’t true. Stock is ownership in a company. When a company’s business is good, the owners are rewarded. It’s that simple.
So, what are bonds? Bonds are loans. When a government or a corporation needs to borrow money, they issue bonds, which is just like you or me going to the bank to borrow money. The interest rates we pay are going to depend on our credit, and on the demand for loans. If the bank is overrun with customers wanting loans, then they can charge higher rates; if we are the only ones in there, then we can negotiate lower rates. Interest rates go up as the economy grows faster.
When the economy grows faster, people buy more products from more companies, which means companies make more money. When companies make more money, stock prices rise. Interest rates and stock prices go up together. The problem with markets is that they tend to get overheated and go too far; that is when stocks go down, and then interest rates go down. Then they do it all over again.
So, are things overheated? With interest rates this question almost answers itself. We have gone from historically low rates to low rates. We have not even really gotten back to normal, so the idea that we are overheating there really is not even being discussed.
Stocks, on the other hand, are coming up on a nine-year bull market run, right? Wrong. This headline is at best misleading and possibly just a lie. It is true that through the marvels of flawed design and questionable math the S&P 500 index has been positive for that many years, but stocks as a whole have not.
The market has corrected several times in the last nine years. We practically had a bear market (by definition, a market down 20 percent in price) in 2015 for every stock except the so-called FANG (Facebook, Amazon, NetFlix, Google) stocks. The FANG stocks then corrected in the beginning of 2016. We are in a bear market right now for Chinese companies, and international stocks as a whole have been hit hard this year. Small company stocks, which had finally come back to life after suffering for most of this nine-year period, have been hit hard of late. So, for anyone who has looked more closely than the most casual observer, this has not been an uninterrupted nine-year run.
This can’t be the end of the nine-year bull market because it has ended and then started again three or four times already. The economy is good; in fact, it is very good. That means rates will rise and companies should continue to report stellar earnings. Any market fluctuations in the meantime are just an opportunity for the long-term investor.
One final thought: Bubbles never burst when people are fretting about this possibly being a bubble. Bubbles burst when everyone is saying, “This time it is different.” In 1999 I was told by a colleague at Invesco that, “valuations don’t matter anymore.” In 2007 I was told by a hedge fund manager that one could “buy mortgage-backed securities and use as much leverage as you need to achieve any return you wish to earn and it is all risk-free.” When people start to talk that way, then we will be nearing the end of the run. Until then, when you see panicky headlines, do what I do and laugh and get ready to go shopping.
Chuck Osborne, CFA