Monday, July 01, 2013

Mitch Zacks on interest rates and the stock market

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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