Fluctuations in interest rates will remain center stage in the second
half of 2013. Usually, the ten-year treasury yield should be about 200
basis points, or 2%, above the inflation rate. Right now, as of the end
of June, the ten-year treasury is yielding 2.5%. The problem is that
inflation is not even close to 0.5%. Most likely, depending on how it
is calculated, core inflation is running around 1.1% annually and
projected to rise to around 1.5% in the third quarter of 2013. This is
below the Federal Reserve’s target of 2% and is also substantially below
the average inflation rate we have seen in the U.S. The current low
inflation rate implies that the ten-year treasury should be over 3%. The
reason the ten-year rate is not that high is because the Federal
Reserve is buying $85 billion dollars of treasuries and mortgage backed
securities each month in order to artificially keep interest rates low.
From 1914 through 2013 annual inflation has averaged 3.35% in the U.S.
This implies that when the economy returns to normal, the yield on
ten-year bonds are likely to at least double from 2.5% to 5%. The 5%
number is arrived at by estimating that inflation will return to
historical norms of 3% and, in the absence of bond buying by the Federal
Reserve, the ten-year treasury will price itself so it yields around 2%
above the inflation rate.
If we estimate that the yield on a ten-year treasury will increase from
2.5% to 5% over a three year period, this implies that ten-year bond
prices will fall roughly 23% over this three year period. Effectively,
if inflation returns to historic levels and the Federal Reserve stops
its bond buying, investors holding treasuries are going to have their
heads handed to them.
Right now the stock market is unfortunately in a damned if you do,
damned if you don’t, state. If the economy recovers stronger than
expected, it will likely cause some inflation and the Federal Reserve
will be forced to taper their bond buying sooner than expected. This
would be a negative for the market. If however, the economy weakens
substantially, earnings estimates will be pulled back and the market
will sell-off.
To head higher, what the stock market really needs is an economy that is
neither too weak, nor too strong. If we see such a goldilocks type of
economy, the stock market will continue to benefit from improving
earnings due to a growing economy and lower interest rates due to the
continued easing by the Federal Reserve. It is starting to look like a
narrower and narrower band that economic growth must materialize in for
the market to continue at the rate it has in the first half of the year.
As a result, the probability of disappointment is growing and I would
not be surprised to see some selling in the second half of the year. At
the end of the day, the right course of action is to keep your eye on
the long-term and ignore the quarterly, or even yearly, fluctuations in
the market. Thus, for the investor with the time horizon of several
years, a market pull-back represents a buying opportunity.
While we are likely going to see some volatility and selling in the
immediate future, the key is to make sure you are positioned so that
despite pullbacks, you can continue to hold equities. Over the long-run,
these quarterly fluctuations in the market that we spend so much time
worrying and analyzing about, really amount to noise. The key, as
always, to making money in the stock market is to be able to hold stocks
for a long period of time and not to overreact to market fluctuations.
[Mitch Zacks runs the Zacks Small-Cap Core Fund (ZSCCX) which has an annual turnover of 173%]
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