We took a break from our monthly videos this summer, but we wanted to bring you up to speed with some updates to the economic / investment landscape. Here are nine interesting (and sometimes head-scratching) charts to summarize the current landscape. Let’s jump in.
Chart #1 – No premium for taking stock-risk
Historically, stocks offer a relative return-premium over bonds and cash due to the higher volatility of returns. Bonds and cash typically have lower expected returns than stocks because of the predictability of cash flows and lower risk profile. It can difficult to compare this relative difference because stocks and bonds are so different. But we can calculate something called the earnings yield to help us visualize the risk / reward tradeoff. Let’s assume that a stock has $1 per share in earnings and trades at $12 per share. The “earnings yield on that stock would be 8.33% or $1 divided by $12. That doesn’t mean that you’re going to earn 8.33% on the investment, but it gives investors a normalized way to measure the attractiveness of stocks, bonds and other interest-bearing investments. As a side, there is a directional correction between earnings-yield and stock performance over an extended period of time. The lower the “earnings yield” the lower the expected return, but it isn’t a perfect correlation. However, as you see in the chart to above, the combination of increased interest rates on cash, falling bond prices and expensive stock values has led to the convergence of “yields” for each of the three asset classes.
Translation: it’s getting more difficult to justify taking on “stock-risk” when bonds and cash likely offer a similar return going forward.
Chart #2 - Not much compensation for bond risk either
The Fed Funds rate is the interest rate that banks pay to borrow money overnight from the Federal Reserve. That rate is usually considerably lower than the interest rate paid by corporations to borrow money from the general public due to the increased risk. While that is still the case, the yield differential is extremely small right now (the red line on the chart).
In other words, bond investors aren’t being compensated very well from the increased risk of lending money to a corporation. This narrow spread has happened before (the little yield semi-circles) and historically it has been followed by some notable declines in the stock market (the yellow arrows pointing to the white line).
Translation – the bond market is giving us warning signs about the stock market.
Chart #3 - No one is moving
The dramatic increase in interest rates has paralyzed home-owners. After all, who wants to sell their home and move if it means trading a 3% mortgage for a 7% mortgage? Not many folks.
As a result, an increasing proportion of homes-for-sale are new construction. This fact doesn’t necessarily translate to an actionable investment takeaway, but it explains why housing inventory is so tight and prices remain elevated despite the increase in interest rates. If / when mortgage rates come back down we may see a flood of movement in the real estate market, which could actually lead to falling prices (a strange phenomena that the text books don’t teach). Regardless, real estate prices continue to defy gravity and are likely to remain high as long as inventory is stained.
Chart #4 – Realtors need more houses
The lack of real estate inventory has reached such extreme levels that there are now fewer single-family on the market than there are TOTAL REALTORS IN AMERICA! Think about that for a moment.
Going back to 1983 (as far back as the data allows) we’ve never seen this. This doesn’t seem great for real estate professionals and it doesn’t bode well for potential buyers looking for a new home.
Chart #5 – Interest rate hikes are taking a toll on the Government as well
The US government has approximately $32.6 Trillion in debt. Most of that debt was accumulated when interest rates were low. In 2022, the total interest expense for government debt was $722 billion, which equates to an effective interest rate of somewhere in the 2-2.3% range depending on how you calculate the debt base at the time. However, as lower yielding bonds mature each year the government will refinance those bonds at higher rates. With interest rates near 4% on long term bonds and above 5% on short-term bonds, it’s doesn’t take a math degree to realize that the amount of interest payments should increase rather quickly in the coming years if interest rates stay elevated.
As indicated in the chart the right, US interest payments now surpass our spending on defense spending. What does this mean for investors? At some point, the government spending should (in theory at least) be constrained by the burden of higher interest rates. If government spending is curtailed it could be a headwind to future growth.
Chart #6 – Borrowing is slowing
Interest rates are catching up with consumers as well. Bank credit growth turned negative year-over-year for only the second time in the last 40+ years and the first time since 2008. Our economy essentially runs on credit (which is a little scary to begin with) and it’s not an encouraging sign that credit is drying up. This chart may be an indication of tighter lending standards (i.e. the banks aren’t as quick to lend), but I suspect it has more to do with a decline in consumer demand. The lack of real estate transactions and the higher rates are putting a lid on large purchases for many consumers.
In the long-run this doesn’t bode well for the broad economy as a while and could be the precurser to a recession. Let’s not forget that private consumer spending accounts for 67.9% of economic output in the US (as measure by GDP). A weakened consumer is difficult to overcome for future economic growth and corporate earnings.
Chart #7 – Some stocks are on fire
The potential slowdown in corporate earnings hasn’t fazed investors… epecially for the high-growth tech-centric names like Meta, Amazon, Apple, Microsoft, Alphabet (Google), Tesla and Nvidia. Those seven stocks are up 58% on average compared a lack-luster 4% average return on the remaining 493 stocks in the S&P 500 index.
This one is a little headscratching. These seven stocks are fine companies but why are these massive companies doing so much better than the rest of the market? Perhaps it’s a perceived flight to safety. Perhaps these companies are more immune to the higher rate environment than their smaller counterparts. Regardless, the outperformance feels a little unjustified at these levels.
Chart #8 – Interest rates are like gravity, but sometimes stocks defy
Warren Buffet explained the impact of interest rates on asset prices like this: "Interest rates are like gravity in valuations. If interest rates are nothing, values can be almost infinite. If interest rates are extremely high, that's a huge gravitational pull on values."
That gravitational pull is even stronger on growth-oriented companies with higher FUTURE earnings. The farther away the “high earnings” are to the present day, the more sensitive to interest rates the value becomes. For a basic example, let’s assume you are trying to determine how much you should pay for an investment that will return $1,000 to you next week. With such a short time-frame, you don’t really care what interest rate are in the broad economy. The investment is worth very close to $1,000 because the payment is very close to coming to fruition. However, if the $1,000 payment isn’t coming for 10 years, you’d be much quicker to do some math and compare the risk-free return you could earn by sticking your money in the bank for 10 years. If you could earn 10% risk-free then the value of the future payment would be a lot lower than if you could only earn 3%.
This was true in 2022. As interest rates rose, the value of “growth-oriented” companies came under pressure. The NASDAQ (a historically growth-centric index) fell some 32%. The future earnings of the companies didn’t change that dramatically, but investors discounted the present-day value of those future earnings by a larger amount due to the higher interest rates.
In 2023, gravity has temporarily ceased to matter. Despite the high(er) interest rates, the NASDAQ has almost recovered all of the 2022 decline while rates have continued increase. The relationship between higher rates and lower valuations appears to have ceased temporarily. The relationship can be expressed visually by comparing the value of the NASDAQ to the value of the 10-year Treasury bond (another instrument that’s extremely sensitive to changes in the interest rate). As indicated in the chart above, that relationship appears to have broken in the fall of 2022.
The only plausible explanation I can come up with is that investors anticipate that the higher rates won’t be here for long. They are trying to front-run the idea of future rate cuts by bidding up the stock prices of companies that would benefit from FALLING rates. This logic only makes sense if (1) rates actually do come down in the near future (2) the falling rates aren’t a by-product of a recession. We. Shall. See.
Chart #9 –Investors aren’t worried
Did you know that you can buy insurance on your investments? Investors can purchase an “option” on a stock that gives them ability to sell that stock to another investor at a set price within a set time frame. This protection is known as a “put option.” The cost of this insurance varies based on investor perception and confidence. It’s a market based on fear and expectation. If times are scary and stocks are doing poorly the cost of a put option is higher. If investors are confident about the future, the demand (and thus the cost) of insurance is lower.
As of the end of July, the cost of insurance is the lowest that we’ve seen since the data began being recorded in 2008. This means that the demand for insurance is low and that investors’ confidence is extremely high.
This doesn’t mean that investors should rush out and buy insurance. Nor is this a signal of a contrarian sell-signal. We saw extremely low demand for investor insurance in 2014, 2017, 2019 and a little bit in 2021. None of those instances saw a significant stock market decline
Overall Takeaway: the rapid increase in interest rates has skewed several aspects of the economy (home owners aren’t moving, bond investors aren’t being compensated for credit risk, banks aren’t lending and government costs are rising dramatically). All the while, the stock market continues to chug along. There are reasons for concern, but investors continue to ignore them. In my opinion, the return (5%+) on cash-like instruments offer the best risk / reward tradeoff at the moment.
Opinions expressed in the attached article are those of the author and are not necessarily those of Raymond James. All opinions are as of this date and are subject to change without notice. Investing involves risk and you may incur a profit or loss regardless of strategy selected, including diversification and asset allocation. Past performance may not be indicative of future results. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. The forgoing is not a recommendation to buy or sell any individual security or any combination of securities.
The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. The NASDAQ composite is an unmanaged index of securities traded on the NASDAQ system. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary. Past performance does not guarantee future results.