When we invest in stocks or bonds, we’re buying the right to cash flow. Bonds usually pay a higher % because companies must pay interest on time or face bankruptcy. Stocks are riskier because companies don’t have to disperse cash to shareholders. They can lose money for years on end with no dividend in sight, or they can simply not pay dividends at all. But the principle of investing in a stock or a bond is the same. You lend money for some share of future cash flow.
This is where we get to the Fed. As a value investor, I try not to time the market or predict macroeconomic cycles. But sometimes knowing the macro lay of the land can help us develop a better investment strategy. Or it can answer very basic questions, like Are American stocks overvalued?
The answer to this question seemingly requires two things: the price of stocks and their expected cash flows. Average that out, and you get the Shiller CAPE, which is flashing red (even with recent market drops). The Shiller CAPE may be flawed (here’s an excellent article on why), but even with its flaws the market looks expensive.
Here’s where we go back to the beginning. If stocks are a promise of future cash flow, then there’s the price of a stock (let’s say $100), the expected future cash flow (say $6 per year) and a third factor: what is the opportunity cost of fronting money for a company? Well, you can keep cash and earn 0%. Or you could buy treasuries and earn 2%. Compare that 6% with the 2% you could get while safely stashing your money in treasuries, and stocks start to look a lot cheaper.
But the Federal Reserve is talking about raising interest rates this year, and that can’t be good for stocks, right? Well, that depends. A lot of conservatives will tell you that we’re living dangerously with a very loose monetary policy. Raise interest rates now before inflation takes off. There’s the folly. Monetary policy is not loose at all. In fact, it’s quite tight. Interest rates do not determine monetary policy. Most important are our expectations. How can you fear higher inflation with 10-year treasuries at 2%? And those rates are dropping (see graph below).
In fact, since the Fed tapered QE3, slowing down it’s money printing, rates have gone down. What? That’s crazy, right? But it’s not. People are buying safe assets to guard against low inflation (or deflation). The Fed talking about raising rates is pushing rates lower. How can that be? Because we’re not certain we’re out of the woods yet. Until the Fed changes its whole paradigm, they will raise rates and be forced to lower them again soon after. Monetary policy will remain tight, meaning lower interest rates for a long time yet. And though stock prices seem high now, in some sense they’re justified because no one expects opportunity to spring up elsewhere. That is until the Fed radically alters its thinking and actually loosens policy to raise our future expectations of inflation.