Following the Lead on Interest Rates Isn’t a Strategy

Building a portfolio based solely on market consensus or projections isn't a strategy – it’s hope based investing.

Interest rates going up has been the consensus view since 2009.  Eventually this view will be right, so far it really hasn’t.  When exactly they go up I am unsure of, though I tend to think later than most. 

One thing I will not due is blindly follow market projections or consensus calls, which appear to be nothing more than throwing darts.  While the recent Fed statement contains “considerable time” before an interest rate increase, futures markets are assuming this will happen mid 2015:

Note:  This chart isn’t easy to read.  The blue line shows the actual Fed Funds rate, which is effectively 0 and has been since mid-2009.  The orange line shows what the futures market is predicting the rate will be in the future at the start of the line (e.g. when rates reached 0 in mid-2009 futures markets expected rates to rise back up quickly and be at 2.50% or so by mid-2010).  Lastly, the green line shows where we currently are that rates are projected to rise in mid-2015 and be at almost 3% by 2017.  Also, this chart was printed before the latest Fed Statement and thus futures markets may have adjusted.

What we can observe in the above charts is that market participants always expected the next rate rise to come and it never did.  Now markets did get better, projecting the rate rise out further and further, but none the less were still off. 

Will it be mid-2015?  Not sure, but even some widely used Fed models project the rate increase will be further out:

What about consensus analyst?  Not much better:

Source:  DoubleLine Funds

As you can see the black line where analysts expect the 10 year to be at year-end.  It has consistently moved down all year, along with interest rates.  Again, analysts have missed the calls on interest and this has been a reoccurring theme since 2009.

I am not advocating totally ignoring projections (though not a terrible idea I must admit and certainly better than the other extreme – following them religiously), nor am I advocating making your own market calls. 

But building a portfolio based solely on market consensus or projections isn’t a strategy – it’s hope based investing.  Instead, 1) make probabilistic assessments 2) have a plan if/when those move against you.

*Please see the important disclosures that apply to this commentary HERE.  The above charts are for illustrative purposes only and do not attempt to predict actual results of any particular investment.

Stocks Should be Okay as Long as Economy is Expanding

• According to the chart below, since 1954, economic expansions tend to be a good time to be invested in stocks (SPX = S&P 500*):

• Some observations:
• As the numbers show, we are about 62 months through this one
• It’s right around the average and median since 1954
• Further, there were 4 expansions longer than this once
• The market return has been greater than average, though the market did have a lower bottom than any market prior
• Valuation level was also at a relative low:
  
• And regardless, there have been 2 expansions where the returns were higher
• Anyway, all this says to me that we aren’t in unprecedented territory in terms of length or stock growth in this expansion…
• And while we might be long in the tooth, nothing in the data indicates we are at extreme levels
• But what if the expansion is ending…
• Maybe the expansion ended this month and we didn’t realize it for 6 months (recessions are usually decided after the fact).  Highly unlikely with GDP coming in at 4.2%, but even so the first 6 months of a recession haven’t been destructive for stock market returns, assuming you hold throughout:
  
• Ok, we likely aren’t in a recession now, but what if we start a recession in 6 months?  After all, the common mantra is that markets lead the economy.  Again, while the returns are likely negative:
  
• Altogether Now:
• Expansions yield solid returns for stocks
• It’s likely we are still in an expansion (note: ISM has been in recession once with ISM at 59 or higher):
  
• Even if we are going into a recession, the months leading up to a recession haven’t had a HUGE drawdown (> 25%), despite a likelihood they will be negative
• Thus, as it’s highly probable the economy is expanding there are potential equity returns that outweigh the risk of a drawdown…
• And as a result waiting to pair back your equity exposure until you are certain the economic fundamentals have deteriorated is likely prudent

*Please see the important disclosures that apply to this commentary HERE.  The above charts are for illustrative purposes only and do not attempt to predict actual results of any particular investment.

Euro Economy = Bad; Euro Stocks = Good (maybe)

1. Europe’s economy is going back in the trash as GDP is flat with even all mighty Germany turning negative (see red bars indicating economic growth from the prior period):
   
2. This has been a persistent theme, since 2009 other developed economies – US, Japan, Britain – have grown faster while Europe has stagnated:
   
3. European stocks have reflected this economic weakness as US stocks (SPX on chart below) have returned much more than European stocks (FEZ on chart below) since the end of 2008 (note: the S&P 500* bottom early March 2009, though chart is intra-month making bottom appear to be February 2009):
   
4. However, this underperformance of European stocks has possibly presented an opportunity though as European stocks are now cheaper (note: cheap stocks in general should have more room to grow than more expensive stocks):
   
5. Further, the ECB has yet to institute quantitative easing (QE), but the rumors are swirling.  In the US, QE worked out nicely for US equity markets as each listed program in the chart below resulted in a subsequent move higher in the stock market:
   
6. Thus, if/when the ECB version of QE it could have a positive effect on European equity prices as it did on the US.  Plus the stocks are relatively cheap so there could be some more room to grow.

Caveat: the trend in the European stocks is weak so for the time being caution should be used.

Note:  On 09/04/14 the ECB cut interest rates and may or may not enact quantitative easing later in the day or in coming months.  European stock markets were higher.  This post was written before today’s news.

*Please see the important disclosures that apply to this commentary HERE.  The above charts are for illustrative purposes only and do not attempt to predict actual results of any particular investment.