A Q1 Letter to Clients: Ben Bernanke on Interest Rates

Meanwhile, forecasts for gains in the U.S. stock market in the remainder of 2015 have been adjusted downwards since late last year. Most analysts take the view that with valuations well above historical averages, growth in U.S. stock prices will be driven by earnings growth rather than expansion of the multiple that the market is willing to pay for profits.

With regard to earnings, this piece from CNBC highlights increasing talk of a “profit recession” in which 2015 will see little or no growth in profits. This article from Reuters highlights two big headwinds for the bottom line among U.S. companies: The energy sector, which makes up almost 10% of the U.S. stock market, has been hit hard by the sharp decline in oil prices since last June, and the sector’s earnings is estimated to drop by over 50% in 2015. And second, the steep rise in the U.S. dollar (up 20% against a basket of global currencies from last June to the end of March) means that multinationals are seeing a drop in the value of their offshore profits when converted to dollars. This has a big impact given that approximately half of the revenue of companies in the S&P 500 comes from outside of the United States.

None of this is to say that stocks can’t continue to advance. – I’ve written in the past about research that no measure has proven accurate in forecasting one-year equity returns – but it does suggest that we should be cautious about our stock allocations and also about the stocks that we own.

Ben Bernanke: “Why are interest rates so low?”

In normal times, when the prospect for stocks is especially uncertain, investors look to increase their exposure to bonds. But given low interest rates and the concern about capital losses when rates rise, many investors don’t find bonds an attractive option. In fact, some clients have asked about reducing their bond allocations below the low point in their target allocation.

Recently former U.S. Federal Reserve Board Chairman Ben Bernanke wrote an article in response to the question, “Why are interest rates so low?”

In this article, Bernanke talks about the challenge for central bankers in finding what economists call the equilibrium interest rate; that is, interest rates which are not so low as to overheat the economy resulting in inflation, but low enough to encourage economic growth by making it attractive for companies and consumers to invest and to spend. Given the slow economic recovery, the equilibrium interest rate has been unusually low around the world. Here’s how Bernanke wrapped up his analysis:

“The state of the economy, not the Fed, is the ultimate determinant of the sustainable level of real returns. This helps explain why real interest rates are low throughout the industrialized world, not just in the United States.”

Other clients have asked me questions in response to talk about a “bubble" in bond prices that could lead to a crash in bond values as interest rates rise, something that could spill over to stocks and to the housing market. Yale economist Robert Shiller, who warned about both the tech bubble in 2000 and the housing bubble in 2005, spoke to this in a recent article titled “How scary is the bond market?”

Shiller applied his research on bond prices as a student 40 years ago to today’s situation. Here is an excerpt from his article:

The explanation that we developed so long ago still fits well enough to encourage the belief that we will not see a crash in the bond market unless central banks tighten monetary policy very sharply (by hiking short-term interest rates) or there is a major spike in inflation … It is true that extraordinarily low long-term bond yields put us outside the range of historical experience. But so would a scenario in which a sudden bond-market crash drags down prices of stocks and housing. When an event has never occurred, it cannot be predicted with any semblance of confidence.

Note to advisors: You can omit the next section to keep the letter shorter

This time last year, some clients questioned the wisdom of owning bonds. Investors who maintained their bond allocations last year got a respectable return on their bonds, even as the bond component helped reduce the level of risk and volatility in their portfolios. This chart from a report by fund company Eaton Vance shows 2014 returns in different types of bonds.

Positioning portfolios going forward

The years since 2008 have seen many periods of uncertainty, and today would be no exception. With stocks at above average valuations, U.S. corporate profits flat or even in decline and interest rates stuck at record low levels, what’s an investor to do?

To help navigate through times like these, I’d like to reiterate our core principles of quality, diversification, maintaining balance and risk management. I’ve written about these before, but they are so thoroughly embedded into our approach that they are worth repeating:

Focus on quality

When interest rates are low, investors are sometimes tempted to increase cash flow by looking at lower quality issuers that pay a higher rate of interest. Similarly, it can be tempting to look at stocks that are paying dividends of 5% or more.

There is an old expression in the investment industry: “More money is lost reaching for yield than at the point of a gun.” Significantly increasing portfolio risk by moving to lower quality stocks and bonds is seldom a prudent strategy. Yes, there are cases where we look to enhance portfolio returns by holding investment-grade corporate bonds that pay higher rates of interest than government bonds or some stocks that feature above average dividends. However, we do this only after thoroughly researching their ability to sustain those payments even in the case of an economic downturn.

Overall, our goal is to build portfolios of high-quality holdings that will withstand economic shocks better than the market as a whole. A key thing that we look for is strong brands and stable cash flows, among the attractions of consumer products companies H.J. Heinz and Kraft General Foods, both acquired by a consortium of companies that included Warren Buffett’s Berkshire Hathaway.

Diversification

In my letter to clients at the end of 2014, I pointed out that another response to expensive markets is to look outside the United States. In late August, Princeton’s Burton Malkiel wrote a Wall Street Journal article titled “Are Stock Prices Headed for a Fall?” In that article, he suggested that investors consider adding emerging-markets stocks to their portfolios. Those stocks’ valuations based on 10-year earnings are more than 40% below that of the U.S. market. Still another strategy is to look selectively at stocks in Europe and Japan that trade at lower levels than comparable U.S. companies.

Diversification doesn’t just mean holding stocks and bonds; it also entails ensuring that there is broad exposure across industry sectors. Investors who were overexposed to the energy sector saw the collapse in oil prices from $150 last June to under $60 today hit their portfolios particularly hard. To point to just one example, Exxon Mobil was the most highly valued company in the world for years, until Apple displaced it in 2011. From last June to the end of March, Exxon’s stock has been off by more than 20%.

Maintaining balance

A key trait of successful investors is ensuring that their portfolios stay balanced. There was a strong performance by stocks over the past number of years. Because of this, unless we took action to reallocate funds along the way, it’s likely that portfolios that had the right balance three years ago are out of balance today with an overweighting to equities. That overweight can lead to greater downside risk than was built into the original portfolio.

Controlling risk

We design portfolios with the view of providing clients with the best possible returns on a risk-adjusted basis when looking across a full market cycle. To do that, we look at the broadest possible range of alternatives, both within the United States and around the world.

Ultimately, every client’s needs are unique, and we work hard to develop the portfolio that is right for your personal risk tolerance and situation. If we haven’t talked recently, we would welcome the opportunity to sit down to update your circumstances, to ensure that your portfolio is designed to provide the returns to achieve your long term goals with no more risk than is necessary. 

I hope that you have found this review helpful. As always, thank you for the opportunity to serve as your financial advisor.

Name of Advisor

P.S. On a final note, the chart below shows stock returns over the past decade. As you can see, investors in U.S. stocks have done especially well over the past five years as equities bounced back from the declines of 2008, with an annual return of over 14% since March of 2010.

Dan Richards conducts programs to help advisors gain and retain clients and is an award winning faculty member in the MBA program at the University of Toronto. To see more of his written commentaries, go to www.danrichards.com or here for his videos.

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