Interest Rates Do Matter

March 2005 Dr. Hans Black

This year has begun in a number of peculiar ways. For one, the stock market, which declined sharply in January, has rebounded sufficiently in February to give the impression that it is nevertheless rising, even though the indices show it is down for the year. Secondly, everyday we are on the receiving end of one or two phone calls asking us if we see any great new bargains. For the most part the answer is no. Indeed, we remain troubled by a whole host of things, not least of which is what we consider to be overpriced stocks in many sectors.

Just over two years ago, on these very pages, we remarked on how many stocks looked cheap and the number of bargains we were finding. Indeed, 2003 and 2004 were very good to us, but now things are remarkably different. Interest rates have been rising (although no one seems to care) as the U.S. central bank is clearly focused on getting some of the extra liquidity out of the system — and will not hesitate to continue as long as it perceives the liquidity sloshing around the system is excessive. As many others have remarked, bonds have so far reacted very little. Indeed, the yield on 10-year bonds is lower today than it was last spring, so we have seen a so-called flattening of the yield curve. Fed chairman, Alan Greenspan, has candidly opined that he is perplexed and believes this to be a “conundrum”. A conundrum indeed! Some other observers have now simply stated that the conundrum derives from the appetite of foreign central banks for longer-term U.S. bonds. We believe that the longer-term bond market is thus more likely discounting some of the very real and persistent collective fears in the market on the subject of deflation. Should, in the coming years, a round of deflation emerge, long-term yields nearing 4.5 percent will be considered great value. What is haunting many, and is clearly on the minds of almost every investment manager, is the question of how precariously we are still perched on the precipice in this inflation-versus-deflation debate. In the last eighteen months, the deflationary concerns of late 2002 have become somewhat dormant. Falling stock prices caused by falling earnings are no longer a prime concern. The stock market has been rising, and indeed the spread between treasuries and lower-quality bonds has narrowed dramatically over the past two years — quite the opposite of what we would expect in a deflationary scare. Members of the Fed who spoke publicly in late 2002 about their deflationary concerns are now silent, and the Fed is responding to the current cyclical inflationary winds with higher interest rates. Higher scrap steel prices, dramatically higher base metal prices, and of course much higher oil prices, have all added to these arguments. The pendulum will therefore likely swing further to a perception that additional tightening is on the way.

The problem with all of this is that eventually the combination of factors will lead to lower corporate profits and then lower stock prices and finally lower commodity prices for a wide variety of goods, thereby fueling deflationary concerns once again. The moment the economy slows down — and indeed housing is already seeing evidence that this is occurring — raw materials prices for a whole variety of elements will decline, and with it the various stocks now being touted as being able to participate in these profits. PHELPS DODGE is an example of a stock that we feel is very vulnerable, as are quite a number of oil stocks and other base metal-related companies. There was a time when we felt shares of A.K. STEEL, the old American Kawasaki, were very cheap trading near $3, but this is hardly the case near $15. Our assumption for the moment is that higher-than-normal cash levels are likely going to give us superior returns for the next several quarters as the stock market becomes less enamored with profit return reports, or the lack thereof.

As one money manager and friend, Seth Klarman, president of Baupost, recently wrote: “Most of the investments we reject as unattractive are quickly scooped up by others more optimistic than we; every day, impatient capital is being poured into investments that offer inadequate return for the risk.”

At the risk of sounding overly alarmist, we are reminded of the situation in mid-1987 when both the stock market and interest rates had been rising for a while with nobody seeming to care. History teaches us that interest rates do matter and that an economy so saturated with debt is particularly sensitive to these changes. While we are not expecting anything of the magnitude of what occurred in the fall of 1987, we do feel that stock prices for a whole variety of groups are quite vulnerable. Ultimately, opportunists with cash available will continue to benefit in this post-2000 bubble environment.