The U.S. stock market showed impressive gains in 2009. The S&P 500 increased over 26%. However, even after an impressive gain in 2009, the S&P 500 experienced a NEGATIVE rate of return for the decade that just ended. That’s correct. An investment in the U.S. stock market from the end of 1999 to the end of 2009 netted you a loss of just under1% per year for ten years.
In contrast, the eighteen-year period prior to 2000 was a very rewarding time to be invested in stocks. There were many years that an investor did not have to be smart in order to look smart. Everyone was a stock market expert in the 90’s. If your investment process assumes that “investment pendulums” swing back and forth, you might be tempted to expect the next decade to be more rewarding.
There are many factors that contribute to the performance of stock prices but the most significant factor during my career has been interest rates. There is a very logical reason for this. The amount that investors are willing to pay for any risky investment is directly related to the return investors can get without taking ANY risk. If I can earn 5% risk-free, I might take a little bit of risk with my investment account. If I can earn 10% risk-free, I will take LESS risk than when the risk-free rate was 5%.
A great example of this is my first day in the investment industry: July 1, 1981. On that day, you could purchase a 3-month Treasury Bill and earn 14.95%. That’s right….you could earn almost 15%….and you could earn it WITHOUT TAKING ANY RISK! Needless to say, investors didn’t see many reasons to invest their money in virtually anything that entailed risk. Investing in stocks in 1981 seemed like such a bad idea that the Dow Jones Industrial Average traded as low as 824.
Over the next 18 years, the “risk-free rate of return” declined (with a couple of hiccups along the way) from 15% to around 1%. As investors earned less risk-free each year, they gradually became more inclined to take risk. Stocks, real estate, corporate bonds, mortgages….all of these became more attractive as interest rates declined. And as the demand for risky investments increased, the prices of those investments increased.
Here’s the point of all this. After the global economic crisis and the ensuing recession, the Federal Reserve felt compelled to take actions that would foster an economic recovery. The Federal Reserve reduced the discount rate to almost zero and held it there for most of 2009. This has caused the Treasury Bill interest rate to also hover around 0%. Because investors can only earn 0% risk-free, they are persuaded to take risk with their money. Oh, they didn’t mind earning 0% when the stock market was plunging 50%. But that only lasted a few months and investors, having short memories, began moving funds back into the same investments that resulted in a negative rate of return for the past decade.
We are not saying the next decade will be like the last one….but if risky investments become more attractive when interest rates decline, it stands to reason that risky investments will look less attractive if interest rates rise. In other words, the prices of risky investments would decline as interest rates increase. If I can earn 5% risk-free today instead of 0%, I will have fewer funds in risky investments (the stock market). If this is the case, then it would obviously be a benefit to know which direction interest rates might trend. Because they are already at 0%, we know they cannot go down. That leaves only sideways and up. We fear the Federal Reserve is creating another environment conducive to investment bubbles by maintaining a low interest rate posture and that, when interest rates eventually rise, it will result in the collapse of those bubbles created by low interest rates.
The other action the Federal Reserve took (and is continuing to take) was to purchase mortgage backed securities. The Fed purchased over $1 trillion of mortgage backed securities in the open market which has had the effect of keeping mortgage rates low.. . . artificially low. The Federal Reserve is trying to keep mortgage rates low to make it easier to finance the purchase of a home. The premise is that increased demand for housing will support home values which, in turn, should improve consumer net worth, consumer confidence and consumer demand.
Meanwhile, the Obama Administration has taken a couple of measures in an attempt to prop up the housing market. Originally, they enacted a program that would give a tax credit to first-time home buyers. That lasted a few months and had minimal impact. So they extended the program and included people buying a home after having lived in a home for at least five years. Of course, if you’re just living in your house, paying your mortgage on time and not moving, you get nothing.
The other program they enacted was the mortgage modification program. This is a vain attempt to fix a problem that Congress not only allowed, but encouraged. My previous Investment Commentaries have discussed the various guilty parties associated with the mortgage and housing crisis. None were guiltier than the members of Congress who thought it would make them look good to state that every American deserved to own a home. After fostering an environment that encouraged millions of Americans to purchase way-too-much house, the mortgage modification program attempts to reduce mortgage payments so those Americans can stay in their “way-too-much” house. Meanwhile, if you did not purchase way-too-much house and you are paying your mortgage on time, you get nothing.
The tax credit is showing some modest results. The National Association of Realtors (NAR) said that the number of previously owned homes in the U.S. under contract for sale jumped 31.8% in October, compared with October, 2008. In addition, the NAR said that sales of existing homes in November increased 7.4% from the previous month and increased 44% from November, 2008. Zillow.com reports that homes in the U.S. lost $489 billion in value during the first 11 months of 2009, significantly less than the $3.6 trillion lost during 2008.
So lower mortgage rates combined with tax credits for home buyers appear to be stemming the tide of cascading home prices. What has been a dismal failure so far has been the Administration’s attempt to modify mortgages. To qualify, eligible homeowners can have their loans “temporarily” modified to reduce their mortgage payments to 31 percent of their income. For the modification to become permanent, the borrower must provide extensive documentation and make three consecutive payments to prove they can afford the loan. A recent report of a Congressional Oversight Panel found that only about 1 percent of borrowers had moved from “temporary” modification to “permanent” modification.
During the month of December, Congress and the Senate both voted to approve health care reform, albeit losing the “public option” along the way. This has been a major focus of politicians since the inauguration one year ago. Meanwhile, unemployment has climbed above 10%. Making health care reform a higher priority than the economy could come at a price to this Administration. In 1992, the Bill Clinton Campaign capitalized on a slow economy and began repeating the phrase, “it’s the economy stupid”. They recognized then what the elder George Bush did not….that the economy is the highest priority to voters. Although the American public has many financial, political and geo-political concerns, being employed and paying bills is at the top.
Most Americans see the need to alter the way health care is delivered (and to whom it is delivered). However, it seems the majority do not share the Administration’s desire for a massive overhaul. If the economy was positive, this health care reform would not be very popular. But with 10% unemployment, it is becoming VERY unpopular….citizens are not happy that health care reform is the number one priority in Washington.
Many Americans are also not happy to see national security take a backseat to health care reform. A 23 year-old Nigerian with explosives in his underpants sitting in 17A is a big problem (particularly if you are sitting in 17B). You can bet the Republicans will point out that the Democratic focus on health care reform has caused them to take their collective eyes off of national security and the economy.
At Boyer & Corporon Wealth Management, we continue to have some grave concerns…..concerns that might not become apparent immediately.
- After the Fed stops purchasing mortgages, mortgage rates will climb, leading to less demand and falling home values.
- When the tax credit for home buyers ends, there will be less demand for homes, causing the values of homes to decline.
- There is another massive wave of bad adjustable-rate mortgages ahead of us. Interest rates will re-set on over a trillion dollars of mortgages over the next 3 years and the attempts to modify these mortgages will have minimal impact. There continue to be over 300,000 foreclosures in the U.S. every month.
- Interest rates will eventually trend up, causing a headwind for stocks and bonds.
- Unemployment is still over 10% and shows no sign of declining. Twenty-five states have run out of funds for unemployment compensation and have borrowed $24 billion from the federal government. It is estimated that 40 state unemployment compensation funds will go broke within two years and need $90 billion in loans to keep issuing benefit checks.
We remain cautious and look for “short duration” securities for our portfolios.
This information is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.