Author Topic: What can Mustachians do to take advantage of "lower for longer" Fed policy?  (Read 2014 times)

ctuser1

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The relevant policy ideas were articulated by the Fed a few months ago: https://apnews.com/article/virus-outbreak-prices-inflation-archive-be741aefe99dea470a504c74b67700da

Summary:
1. Interest rates to stay in the 0.00%-0.25% range till 2023, perhaps longer.
    I don't think Fed has ever been so specific in signaling it's dovish intentions so far into the future. So this is remarkable!

2. It is going to be very sensitive to the unemployment rate.
    This is not remarkable. Everyone expects this.

3. It is most likely going to allow inflation, and inflation expectation to overshoot for an extended period before it revisits the interest rate policy.
    This again, coupled with #1, is much further than at least I know of that Fed has ever gone before.

4. (This has not been explicitly articulated by the Fed) It seems that the fiscal and monetary policy are now working hand in hand, and I anticipate that the markets will bake in that expectation in future. I don't know if this is good or bad. I personally feel a little uncomfortable that the Fed is no longer expected to be as independent as they historically were.

The reason I did not start a topic on this back in Sept when this was formally articulated is that there were a lot of uncertainties into the air at that point of time. Most of them have cleared out now and I think the future expectations are sufficiently clear now to strategize at a personal finance level.

Expected real world implications of the above policy:
1. Mortgage rates will stay low, and will likely creep lower. The 10Y treasury to average mortgage rate spread is much wider today than it has historically been (by > 60 basis points). This gap should get smaller over time. 10Y treasury won't likely go up till 2023, so the only way for the mortgage rates it for them to creep downwards.
2. There will be a strong tailwind behind the stock market for the next few years. The main street will not be left behind either. The Fed expects 4.2% growth in 2021, wayyyy above the secular growth rate of 1.8% of the US economy. The main street growth rate is apparently not expected to settle back down to the secular growth rate till 2024. Fed tailwind + main street growth = recipe for a bubble forming for the next half a decade.

So what do I do to take advantage of the above:
1. Another refi in 2021, or 2022. I am not sure if I would want to do cash-out refi at that point or just refi into an even shorter term so pay the house off faster. That is a math vs. gut-feel comfort question that every person will need to decide on his own.

2. My IPS calls for a risk-on position into my "Lean-FI". e.g. my 2012 investment into AAPL has grown to 42.6% of my total portfolio as of today morning. I'm not touching that yet, till I get to Lean-FI. I am @ 70% towards my Lean-FI number as of today morning. Once I reach this number, I have to reconsider my risk appetite. Depending on when I reach this point there will be a strong temptation to let the risk-on position to ride on longer - but that will be market timing and I need to resist that. At a minimum, the single stock positions need to go and I need to simplify to a two-fund (or maybe a three-fund) portfolio once I reach lean-FI. I'll re-position my portfolio after it stays above lean-FI for at least 6 months, and before it stays above that mark for 1 year. This will allow me to think through things and avoid knee-jerk reactions.

So, what are your thoughts and practical next steps regarding the Fed stance outlined above?
 

effigy98

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Leverage up and buy real assets and get ready for inflation. Is there any time in history interest rates have been this low? What a great opportunity. If the dems take Georgia on the 5th, this is the bet I'm going with.

yachi

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1. Stay away from Bonds and CD's.  Most are not paying above the Fed's inflation goal of 2%
2. I agree with staying in stocks until you reach your FIRE goals
3. Borrow what you can at low interest rates
4. Consider taking on capital projects that reduce your ongoing expenses to reduce the impact of future inflation.  Solar power, greater insulation

bwall

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Leverage up and buy real assets and get ready for inflation. Is there any time in history interest rates have been this low? What a great opportunity. If the dems take Georgia on the 5th, this is the bet I'm going with.

Coming inflation is not a sure thing. Or, at least not as sure as it seems. Most economists are worried about deflation these days.

Here's why: since the financial crisis the money supply has triple for quadrupled or quintupled now with COVID. Normally this would herald a sharp increase in inflation, but that didn't happen.
Potential culprits:
1) demographic change (aging US population in no way resembles the US population of the last inflation surge in the 1970's)
2) No bank lending (lack of demand worldwide)
3) Lack of projects soaking up large investment dollars
4) China's huge increase in foreign reserves.
5) Stagnate wages/lower taxes in US leading to decline in the middle class (see lack of demand #2).
6) Something else.

So, levering up and buying assets is not guaranteed that the loans can be paid off with cheaper dollars via inflation. 

vand

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Leverage up and buy real assets and get ready for inflation. Is there any time in history interest rates have been this low? What a great opportunity. If the dems take Georgia on the 5th, this is the bet I'm going with.

Agreed.

Leverage up as much as you are comfortable doing with long term fixed rate debt and then run an all weather-style portfolio. While inflation isn't guaranteed, it should absolutely not be totally discounted either, and in any case equities are so richly valued that returns in other assets could be much better even without inflation.

Even better if you have good positive monthly cashflow (ie a high savings rate) which hopefully you do, which itself acts a good margin of safety.
« Last Edit: December 29, 2020, 09:07:16 AM by vand »

ChpBstrd

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Leverage up and buy real assets and get ready for inflation. Is there any time in history interest rates have been this low? What a great opportunity. If the dems take Georgia on the 5th, this is the bet I'm going with.

Coming inflation is not a sure thing. Or, at least not as sure as it seems. Most economists are worried about deflation these days.

Here's why: since the financial crisis the money supply has triple for quadrupled or quintupled now with COVID. Normally this would herald a sharp increase in inflation, but that didn't happen.
Potential culprits:
1) demographic change (aging US population in no way resembles the US population of the last inflation surge in the 1970's)
2) No bank lending (lack of demand worldwide)
3) Lack of projects soaking up large investment dollars
4) China's huge increase in foreign reserves.
5) Stagnate wages/lower taxes in US leading to decline in the middle class (see lack of demand #2).
6) Something else.

So, levering up and buying assets is not guaranteed that the loans can be paid off with cheaper dollars via inflation.

I agree that inflation is not at all a "sure thing". All the reasons for inflation cited today were in place for the past decade, when we barely managed 2%. Under the "something else" category I'll add:

6(a) Industrial concentration as seen in Japan since the late 1980s. When prices are already at the level that maximizes profit in a monopolistic industry, the industry will not raise their margins further. Additionally, when a handful of highly efficient established companies create a barrier to market entrants, there is less pressure to spend on marketing, R&D, efficiency, expansion, etc. which reduces cost at the company's level increasing barriers to entry, and aggregate demand at the national level, decreasing inflationary pressures. The US has had decades of almost-unrestricted anticompetitive mergers and many markets have reached a sort of mummified stasis. This is related to #2, #3, and #5 above. A stronger antitrust stance by the federal government or more disruptive technologies could change this dynamic.

6(b) The increase in "economic inequality" could be restated as an increase in "cash hoarding" by the rich. While the declining and aging middle class (#1 and #5) reduce demand for products and services, the growing upper class increases demand for cash/treasuries. Our current configuration is the economic equivalent of the rich being handed treasuries instead of paying taxes. Research shows that cash in the hands of the rich gets spent at a much lower velocity than cash in the hands of the poor, so as the economic system is configured to put cash into the hands of the rich a lot of the increase in money supply went to sit in a few million $50k checking accounts and CDs, at a bank that is buying treasuries with the money rather than investing in projects (#2 and #3). A major overhaul of the currently anti-progressive tax code could change this.

6(c) High inflation for medical care, housing, and education are sucking away demand for other categories, and will likely continue doing so. The escalating costs in these government-subsidized industries function the same as a rising tax that reduces monetary velocity, and as a reason to increase savings rates. E.g. You spend less of your paycheck when you have to save for a $500k college degree or house, or when a quarter of your paycheck goes to insurance.

6(d) The experience of people who were young adults during the last 10 years of market crashes, college debt, and the pandemic could increase their propensity to save and hoard money, compared to baby boomers or gen X (who prioritized cars and houses). This is related to #1 and #5, but more psychological/behavioral. 

bwall

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@ChpBstrd ; Great analysis. I find myself nodding my head in agreement to all your points above...... I just wish I'd thought of those points as I was making my list.

ChpBstrd

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In terms of how to take advantage, I'd be careful about falling into a trap where low rates are the bait. Sure, refinancing one's mortgage is probably a no-brainer, but on the flip side one is either missing out on interest on the cash/bonds portion of one's account OR taking more risk in one's portfolio in a reach for yield. Low rates are a net negative for savers like us. 

The game everyone is playing right now is to borrow low (mortgage or margin) and invest at a higher tier of risk (junk bonds, equities). This game of musical chairs could last a long time, or it could end at any time with lots of people ruined. Leverage kills as surely as gravity. It only sounds like a rational idea today because market prices have been going up so much.

Even worse, low rates have pushed equity valuations to levels last seen prior to two major valuation crashes: 1929 and 1999.https://www.multpl.com/shiller-pe Because earnings are the foundation of an equity portfolio's durability, this means that equities are far less safe than in most of the stock market's history. With a PE ratio over 37, the S&P 500 has an earnings yield of 2.7%, far less than a 4% WR. With bonds yielding even less than that, it's hard to imagine a retiree's portfolio not declining unless the PE somehow continues inflating or earnings growth goes astronomical.

Instead of looking at how to "take advantage" I suggest looking for ways to avoid much of the risk, riding the bubble up at 100% equities with a safety net to catch you when it pops. I like the idea of hedging with options because interest rates have a relatively minor effect on an option's price, and because you can know you are "buying" volatility low with clear statistics like the VIX and implied volatility.

The other bright side is you can easily hedge inflation risk by buying cheap way-out-of-the-money puts on things like TLT or PFF. Both will drop 30%+ if inflation runs hot, as in 4-5%. Options pricing formulas price the puts cheaply because inflation hasn't increased for such a long time. To be clear, interest rates in the historically typical 3-5% range would trigger an economic crisis many times bigger than 2008 given the trillions of dollars parked in long-duration fixed income assets tied to rates in the 0-1% range. Anyone predicting a return to normal inflation within a few years should be 90% cash, 10% long put options on the stock indexes - way out of the money, and ready to roll the puts as they expire. That's not me, but just saying.

vand

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Can I also point out that you don't necessarily need to actively do anything to take advantage. Equities already carry gearing as virtually all companies finance to some extent with debt, and the current interest rate environment is just gravy for all CFOS who can issue now debt and refinance at stupid rates.


bthewalls

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Great thread. Been waiting for someone to throw out educated opinion of whatís going on.

Iím also quite interested to know what happens after main central banks stop qe....or can they in the short term I.e. what happens when means of stimulus runout or effect deminishes?

Travis

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Re: What can Mustachians do to take advantage of "lower for longer" Fed policy?
« Reply #10 on: December 29, 2020, 06:18:25 PM »
Not an expert by any stretch, but the following scenario jumped out at me with the latest COVID relief getting approved and your discussion of low or lower rates:

-What does the housing market look like after people start going back to work and these mortgage payment/deferments/eviction forgiveness periods end? Will there be some kind of unraveling, uncoiling, reality check event?  I can't imagine it'll be as simple as just paying next month's rent and going on as if the previous year didn't happen.

My own deeply uneducated opinion is that there will be bankruptcies/foreclosures/buying opportunities for landlords or new homeowners who have been sitting on cash, but not to the extent of 2008/2009.  How many landlords right now have been stuck with reduced or zero rent payments for a year who either have struggled or might want to get out of the game?

ChpBstrd

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Re: What can Mustachians do to take advantage of "lower for longer" Fed policy?
« Reply #11 on: December 29, 2020, 09:17:11 PM »
Iím also quite interested to know what happens after main central banks stop qe....or can they in the short term I.e. what happens when means of stimulus runout or effect deminishes?

If inflation started to get out of bounds, the fed will not be able to raise interest rates because that would set off a financial crisis. Bond convexity is insane near the zero boundary, and this is people's "safe" money!

Therefore, the fed will use QE and QT to control inflation for the foreseeable future, leaving interest rates dirt-low. QE/QT are more powerful and precise tools than interest rates anyway, and the collateral damage is far less. The trillions of dollars of assets on the fed's balance sheet could be sold off to suck dollars out of the economy, or trillions more dollars of assets could be added to the balance sheet to add dollars to the economy. There's plenty of ballast either way.

-What does the housing market look like after people start going back to work and these mortgage payment/deferments/eviction forgiveness periods end? Will there be some kind of unraveling, uncoiling, reality check event?  I can't imagine it'll be as simple as just paying next month's rent and going on as if the previous year didn't happen.

My own deeply uneducated opinion is that there will be bankruptcies/foreclosures/buying opportunities for landlords or new homeowners who have been sitting on cash, but not to the extent of 2008/2009.  How many landlords right now have been stuck with reduced or zero rent payments for a year who either have struggled or might want to get out of the game?

The evictions will start as soon as they can start. I think a lot of landlords, especially new ones, will want out of the game. Others will be foreclosed out of the game. It might be a good time to get into RE, particularly urban RE, but the valuations in coastal markets are still insane. A rise in interest rates could bring them down, but that's not happening as I explained above. I'd say pick up REITs or leveraged RE in LCOL areas, but don't pay $2M for a coastal property that nets $250/mo when all goes well.

ctuser1

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Re: What can Mustachians do to take advantage of "lower for longer" Fed policy?
« Reply #12 on: December 29, 2020, 09:38:21 PM »
The evictions will start as soon as they can start. I think a lot of landlords, especially new ones, will want out of the game. Others will be foreclosed out of the game. It might be a good time to get into RE, particularly urban RE, but the valuations in coastal markets are still insane. A rise in interest rates could bring them down, but that's not happening as I explained above. I'd say pick up REITs or leveraged RE in LCOL areas, but don't pay $2M for a coastal property that nets $250/mo when all goes well.

I *think* there is a possibility that corporations will start opening up more satellite offices in far out suburbs near the large city. For the part of work that can't be WFH, social distancing will likely need to be baked into the new office space guidelines even after the pandemic is over. That would make Manhattan/SF/Boston real estate way too expensive. With nearby satellite offices, you preserve the flexibility to have people come over to Manhattan for meetings, but still pay a fraction (less than a tenth in many cases, I was told) for the office space.

We will know if this is happening or not by the beginning of 2022. If it does start, then several of these far out "exurb" areas could likely become very interesting for RE investment. Once you go out of the commute range (75 minutes by the train-timetable out of GCT/Penn seem to be the magic mark for Manhattan), the crazy house prices go away and you can still get pretty reasonably priced real estate.

« Last Edit: December 29, 2020, 09:43:05 PM by ctuser1 »

Travis

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Re: What can Mustachians do to take advantage of "lower for longer" Fed policy?
« Reply #13 on: December 30, 2020, 04:08:08 AM »
The evictions will start as soon as they can start. I think a lot of landlords, especially new ones, will want out of the game. Others will be foreclosed out of the game. It might be a good time to get into RE, particularly urban RE, but the valuations in coastal markets are still insane. A rise in interest rates could bring them down, but that's not happening as I explained above. I'd say pick up REITs or leveraged RE in LCOL areas, but don't pay $2M for a coastal property that nets $250/mo when all goes well.

I *think* there is a possibility that corporations will start opening up more satellite offices in far out suburbs near the large city. For the part of work that can't be WFH, social distancing will likely need to be baked into the new office space guidelines even after the pandemic is over. That would make Manhattan/SF/Boston real estate way too expensive. With nearby satellite offices, you preserve the flexibility to have people come over to Manhattan for meetings, but still pay a fraction (less than a tenth in many cases, I was told) for the office space.

We will know if this is happening or not by the beginning of 2022. If it does start, then several of these far out "exurb" areas could likely become very interesting for RE investment. Once you go out of the commute range (75 minutes by the train-timetable out of GCT/Penn seem to be the magic mark for Manhattan), the crazy house prices go away and you can still get pretty reasonably priced real estate.

Coastal hubs like SF, Seattle, and NY seem to be pretty much immune from the real estate/financial markets. Short of an asteroid or an entire industry becoming obsolete, those RE markets will never change.  My hometown and possible FIRE location is within commuting distance of SF. It's always been CA suburbia, but in the last decade the Bay Area's "commuting range" has extended to include my home which is 2 hours away in good traffic.  A lot of people I grew up with are being priced out of our hometown and are moving out of CA, often taking their income with them to Portland, Phoenix, Austin, or Boise. If after the COVID dust settles a number of those Bay Area employers decide to expand WFH opportunities with the same pay, those RE markets are going to be insane, especially if there are a number of sell-offs/evictions/foreclosures.

bwall

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Re: What can Mustachians do to take advantage of "lower for longer" Fed policy?
« Reply #14 on: December 30, 2020, 04:35:56 AM »
In terms of how to take advantage, I'd be careful about falling into a trap where low rates are the bait. Sure, refinancing one's mortgage is probably a no-brainer, but on the flip side one is either missing out on interest on the cash/bonds portion of one's account OR taking more risk in one's portfolio in a reach for yield. Low rates are a net negative for savers like us. 

The game everyone is playing right now is to borrow low (mortgage or margin) and invest at a higher tier of risk (junk bonds, equities). This game of musical chairs could last a long time, or it could end at any time with lots of people ruined. Leverage kills as surely as gravity. It only sounds like a rational idea today because market prices have been going up so much.

The statements in bold reminds me of the axiom "You can't borrow your way to prosperity."

stoaX

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Re: What can Mustachians do to take advantage of "lower for longer" Fed policy?
« Reply #15 on: December 30, 2020, 05:21:03 AM »
Great topic. PTF. 

tooqk4u22

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Re: What can Mustachians do to take advantage of "lower for longer" Fed policy?
« Reply #16 on: December 30, 2020, 10:23:58 AM »
In terms of how to take advantage, I'd be careful about falling into a trap where low rates are the bait. Sure, refinancing one's mortgage is probably a no-brainer, but on the flip side one is either missing out on interest on the cash/bonds portion of one's account OR taking more risk in one's portfolio in a reach for yield. Low rates are a net negative for savers like us. 

The game everyone is playing right now is to borrow low (mortgage or margin) and invest at a higher tier of risk (junk bonds, equities). This game of musical chairs could last a long time, or it could end at any time with lots of people ruined. Leverage kills as surely as gravity. It only sounds like a rational idea today because market prices have been going up so much.

Even worse, low rates have pushed equity valuations to levels last seen prior to two major valuation crashes: 1929 and 1999.https://www.multpl.com/shiller-pe Because earnings are the foundation of an equity portfolio's durability, this means that equities are far less safe than in most of the stock market's history. With a PE ratio over 37, the S&P 500 has an earnings yield of 2.7%, far less than a 4% WR. With bonds yielding even less than that, it's hard to imagine a retiree's portfolio not declining unless the PE somehow continues inflating or earnings growth goes astronomical.

Instead of looking at how to "take advantage" I suggest looking for ways to avoid much of the risk, riding the bubble up at 100% equities with a safety net to catch you when it pops. I like the idea of hedging with options because interest rates have a relatively minor effect on an option's price, and because you can know you are "buying" volatility low with clear statistics like the VIX and implied volatility.

The other bright side is you can easily hedge inflation risk by buying cheap way-out-of-the-money puts on things like TLT or PFF. Both will drop 30%+ if inflation runs hot, as in 4-5%. Options pricing formulas price the puts cheaply because inflation hasn't increased for such a long time. To be clear, interest rates in the historically typical 3-5% range would trigger an economic crisis many times bigger than 2008 given the trillions of dollars parked in long-duration fixed income assets tied to rates in the 0-1% range. Anyone predicting a return to normal inflation within a few years should be 90% cash, 10% long put options on the stock indexes - way out of the money, and ready to roll the puts as they expire. That's not me, but just saying.

Good post ChpBstrd.   Leverage is 100% the think that kills when things break down, this is true for individuals, business,  and markets.  Doesn't mean not to have any but it should be used appropriately and modestly.  There is a reason why a lot of companies have minimal leverage or if they do from floating bonds they simply keep the cash on their balance sheet - essentially having a cash reserve on somebody else's dime that today costs almost nothing (esecially inflation adjusted).

You are spot on about the game - people are refinancing left and right to extend out payments, cash out, or do major home improvements.  Also causing a lot of new buyers to jump in at significant higher prices because their payments are "So Low!"   Had a younger former co-worker recently buy a house and said that they just bought the max price they could get because they money was basically free. 

Not to mention that margin debt is at an all time high - see below



Ha, PE 37 - it seemed not that long ago when everybody was crying the sky will fall when the PE was in the 20-25 range (me included) - just crazy that the sentiment now is that it can't stop going up.   

I like the idea of using the VIX as a hedge but it is still fairly high historically (with the exception of this year) so I am not sure its at the right number for a hedge for me now, below 20 maybe a bit and definitely below 15.
« Last Edit: December 30, 2020, 10:26:07 AM by tooqk4u22 »

ctuser1

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Re: What can Mustachians do to take advantage of "lower for longer" Fed policy?
« Reply #17 on: December 30, 2020, 10:45:54 AM »
Ha, PE 37 - it seemed not that long ago when everybody was crying the sky will fall when the PE was in the 20-25 range (me included) - just crazy that the sentiment now is that it can't stop going up.   

Intrinsic value of stocks is very tightly dependent on risk free rate.
https://www.investopedia.com/articles/basics/12/intrinsic-value.asp

V0 = BV0 + Σ RIt / (1+r)t
Where

BV0 = Current book value of equity
RIt = Residual income at time period t
r = Cost of equity

This last thing, r = Cost of Funding => directly tied to the interest rate. I personally write code for a system where we have a cost of funding/equity curve that goes from 4% to 12%. With the current interest rate, it will generally be much closer to 4% than 12%.

I just did a quick spreadsheet with a company with book value = $100, yearly earning = $100, that folds after year 10. With 12% cost of funding, the intrinsic value came to be $665, and with 4%, it came to $747. i.e. a 12.33% increase in this simplistic model. In real world, the models get screwy close to 0% (far out cashflow is no longer discounted, and hence intrinsic value starts jumping much higher).


So the PE25 -> PE37 jump is not at all weird based just on the interest rates, assuming that you also assume that the interest rates are not going up (which seems to be a consensus the market has baked in).


There are other models of intrinsic value calculations. All of them are similarly affected by the interest rate, because all of them have to discount some future cashflow/earning.

 


tooqk4u22

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Re: What can Mustachians do to take advantage of "lower for longer" Fed policy?
« Reply #18 on: December 30, 2020, 01:15:06 PM »
Of course they are correlated with interest rates and money supply both of which are at absurd levels and doesn't mean markets can't or aren't out of whack.   Also doesn't mean that fed/treasury policies are prudent. 

A 2.7% earnings yield doesn't seem to make all that much sense relative to a long term 10Y UST risk free rate,  earnings won't grow that much.  Doesn't mean there is a crash but could be flat as earnings catch up over time. 

ChpBstrd

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Re: What can Mustachians do to take advantage of "lower for longer" Fed policy?
« Reply #19 on: December 30, 2020, 04:05:53 PM »
Ha, PE 37 - it seemed not that long ago when everybody was crying the sky will fall when the PE was in the 20-25 range (me included) - just crazy that the sentiment now is that it can't stop going up.   

Intrinsic value of stocks is very tightly dependent on risk free rate.
https://www.investopedia.com/articles/basics/12/intrinsic-value.asp

V0 = BV0 + Σ RIt / (1+r)t
Where

BV0 = Current book value of equity
RIt = Residual income at time period t
r = Cost of equity

This last thing, r = Cost of Funding => directly tied to the interest rate. I personally write code for a system where we have a cost of funding/equity curve that goes from 4% to 12%. With the current interest rate, it will generally be much closer to 4% than 12%.

I just did a quick spreadsheet with a company with book value = $100, yearly earning = $100, that folds after year 10. With 12% cost of funding, the intrinsic value came to be $665, and with 4%, it came to $747. i.e. a 12.33% increase in this simplistic model. In real world, the models get screwy close to 0% (far out cashflow is no longer discounted, and hence intrinsic value starts jumping much higher).


So the PE25 -> PE37 jump is not at all weird based just on the interest rates, assuming that you also assume that the interest rates are not going up (which seems to be a consensus the market has baked in).


There are other models of intrinsic value calculations. All of them are similarly affected by the interest rate, because all of them have to discount some future cashflow/earning.

I agree this is the math, but the thing not captured in this financial model is that when one buys a stock or a bond at a time when the risk free rate is <1%, there is a lopsided risk of loss due to either interest rate increases or earnings decreases. That is, as the risk-free rate goes lower and lower, the riskiness of risk assets increases. To illustrate:

When the risk-free rate is 6%, a risk model used to assess a bond might assign an equal probability to the chance that the rate drops to 2% as it does to the rate rising to 10%. Both are clearly possible. When the risk-free rate is 1%, however, the odds of it dropping by 4% (to negative 3%) is much less than the chance of it rising 4%. The risk distribution would need to be skewed to account for the near-impossibility of negative 3% rates. So as we approach zero the probability of a loss on the bond, or a stock, due to interest rate changes becomes relatively larger than the probability of a gain.

With regard to the equation, the (1+r)^t denominator used in both the residual income and DCF models produces the following results for 10 years at various risk free rates:

Risk Free Rate     Denominator
15%                   4.05
10%                   2.59
5%                     1.63
1%                     1.10
0%                     1

Thus, at around 0% the security is valued as the sum of residual incomes or cash flows. If loans were free and inflation was nothing, an asset would be worth exactly its future cash flows and a dollar today would be worth the same as a dollar in ten years.

Now what happens if we use a 15 year timeframe, where we have 50% more cash flows?

Risk Free Rate     Denominator
15%                   8.14   <100.9% higher than 10 year timeframe
10%                   4.18   <61.4% higher
5%                     2.08   <27.6% higher
1%                     1.16   <5.5% higher
0%                     1        <equal to 10y timeframe

So the higher risk-free rates go, the more sensitive these equations are to the timeframe we select for expected cashflows or RI. It's not linear like our cash flow or RI assumptions. This makes sense because carrying a loan at the risk-free rate or passing up the risk-free rate of interest has a cost that compounds and eventually overwhelms the value of those future cash flows. Another way to look at it: inflation depletes the value of those future cash flows in terms of today's dollars. At a 15% risk free rate, we get 50% more cash flows but have a 100% larger denominator! It would seem the equation was made for a world between 5 and 10%, where the increase in the denominator and numerator is more proportional.

If we chose 5 years or 2 years as the timeframe, we would get lower denominators for the high risk-free rates. But... at near zero percent the denominator would still be one in any timeframe. So now that rates are near zero, the price of an asset is the sum of its future cash flows (or BV plus that in the RI approach). Are assets worth 5 years' cash flows, 10 years', 11 years', or 20 years'?

Consider a company that earns $10 a year. At a 0% risk-free rate, its DCF value is literally the sum of its cash flows because the denominator is one. If you pick 10 years as your timeframe, the value is $100. If you pick 9 years, the value is $90. If you pick 40 years, the value is $400. Obviously, we're just picking timeframes for how long we expect the earnings to last and getting radically different answers. Our estimates of the company's earnings 10 years out are almost certainly wrong, and the risk-free rate may be higher at that time, but there is no discounting to address that uncertainty. There is also no probabilistic skew to what the expected risk free rate will be in each of the future years, unless you do some fancy guesswork. At zero, the $10 earned in every year X adds $10 to the value of the company, period.

DCF value of company earning $10/year

Risk Free Rate     15y          10y          5y
15%                   58.43       50.19       33.52
10%                   76.06       61.44       37.91
5%                     103.79     77.22       43.29
1%                     138.65     94.71       48.53
0%                     150          100          50

Conclusions:

1) As interest rates get really low, stocks become more sensitive to projections of far-off earnings. I.e. At zero, if the earnings only last 10y instead of 15y, the stock needs to drop 33%. At 15% the stock would only drop 14%. This represents higher "bad news" risk for investors.

2) As interest rates get really low, the phenomenon of convexity becomes a bigger danger for stock investors. Look at the 10y DCF numbers. If rates go from 10% to 15%, the stock drops 18.3%, but the same size change going from 0% to 5% would cause the stock to drop 22.8%.

3) In theory, these higher risks to investors should be part of the discount rate. DCF and RI models assume these risks are reflected in the risk free rate and, by extension, inflation. To avoid spiraling deeper and deeper into risk as rates go down, we would need some sort of counterbalance. The risk-free rate plus some sliding-scale risk premium would add up to our "willingness to pay" rate, so that our r never approaches zero and so that very distant cash flows are adequately discounted when rates are low.

/dissertation
#and sorry for the time suck



ctuser1

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I agree this is the math, but the thing not captured in this financial model is that when one buys a stock or a bond at a time when the risk free rate is <1%, there is a lopsided risk of loss due to either interest rate increases(1) or earnings decreases(2).

Rephrasing, to make sure I have understood your point:

(1) -> d(stock price) / d(interest rate) is much higher with rates so low.
                      -> IR Sensitivity is much higher.
                      -> Fed is basically giving up one tool in it's arsenal for good. They can no longer raise the interest rates, even if the inflation was to shoot up, say, 10/20/30 years hence.
                      -> Enhanced structural risk not accounted for in the Intrinsic value or DCF formula.


(2) -> This one feels a little more tricky to express mathematically. I tried to think in terms of vega risk (=d(price)/d(vol)) but could not come up with anything interesting. But basically, the stock price is way too sensitive to the volatility of the underlying earnings wayyy out into the future. This *should* be accounted for by some sort of time-decay, but the intrinsic value or DCF models do not do so, only IR based discounting.

Have I understood your points?

------------------------

Assuming I have understood it correctly, the stock prices should *still* increase with IR going down, but the increase should be less than predicted by the DCF models to account for the enhanced IR sensitivity and other risks.

Is this what you were trying to say? Or did you want to make a bigger point that I missed?

ChpBstrd

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I agree this is the math, but the thing not captured in this financial model is that when one buys a stock or a bond at a time when the risk free rate is <1%, there is a lopsided risk of loss due to either interest rate increases(1) or earnings decreases(2).

Rephrasing, to make sure I have understood your point:

(1) -> d(stock price) / d(interest rate) is much higher with rates so low.
                      -> IR Sensitivity is much higher.
                      -> Fed is basically giving up one tool in it's arsenal for good. They can no longer raise the interest rates, even if the inflation was to shoot up, say, 10/20/30 years hence.
                      -> Enhanced structural risk not accounted for in the Intrinsic value or DCF formula.


(2) -> This one feels a little more tricky to express mathematically. I tried to think in terms of vega risk (=d(price)/d(vol)) but could not come up with anything interesting. But basically, the stock price is way too sensitive to the volatility of the underlying earnings wayyy out into the future. This *should* be accounted for by some sort of time-decay, but the intrinsic value or DCF models do not do so, only IR based discounting.

Have I understood your points?

------------------------

Assuming I have understood it correctly, the stock prices should *still* increase with IR going down, but the increase should be less than predicted by the DCF models to account for the enhanced IR sensitivity and other risks.

Is this what you were trying to say? Or did you want to make a bigger point that I missed?

You're accurate. Perhaps the TL;DR is this: When PE ratios are high, the textbook interpretation is that investors anticipate fast earnings growth in the future. Yet the justification right now for high PE's is that low interest rates / TINA make even low-growth earnings streams valuable. So which is it? Isn't it kinda shaky to switch back and forth between rationales?

Do low interest rates always mean fast growth? Japan might beg to differ. If far-out undiscounted earnings estimates are ever reduced, will that justify a nearly dollar-for-dollar reduction in the value of the stock? If inflation is allowed to exceed interest rates for a long time, doesn't that come out of investors' pockets? In hindsight, the best times to invest were when interest rates were high and PE's low (e.g. 1982), and the worst times to invest were when interest rates were far lower and PE's high (e.g. 1999). Right now, there is little room for optimism on interest rates going lower OR earnings expectations going even higher. So we have two ways to lose instead of the normal one.

Draw a 2x2 matrix with interest rates and earnings growth higher or lower.

Interest rates rising, earnings growth high ---> stocks underperform because of increased discounting and merely meeting expectations.

Interest rates rising, earnings growth low ---> stocks tank because already-high PE's not justified with low growth, plus competition from bonds

Interest rates falling, earnings growth high ---> how likely is it really for the 10y yield to go negative in the US as it has done in Europe, when the fed had already indicated a strong preference not to go negative, and to instead use QE/QT? Falling rates and meeting high growth expectations is the one growth scenario.

Interest rates falling, earnings growth low ---> Japan scenario. Lost decades. 



ctuser1

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The evictions will start as soon as they can start. I think a lot of landlords, especially new ones, will want out of the game. Others will be foreclosed out of the game. It might be a good time to get into RE, particularly urban RE, but the valuations in coastal markets are still insane. A rise in interest rates could bring them down, but that's not happening as I explained above. I'd say pick up REITs or leveraged RE in LCOL areas, but don't pay $2M for a coastal property that nets $250/mo when all goes well.

I *think* there is a possibility that corporations will start opening up more satellite offices in far out suburbs near the large city. For the part of work that can't be WFH, social distancing will likely need to be baked into the new office space guidelines even after the pandemic is over. That would make Manhattan/SF/Boston real estate way too expensive. With nearby satellite offices, you preserve the flexibility to have people come over to Manhattan for meetings, but still pay a fraction (less than a tenth in many cases, I was told) for the office space.

We will know if this is happening or not by the beginning of 2022. If it does start, then several of these far out "exurb" areas could likely become very interesting for RE investment. Once you go out of the commute range (75 minutes by the train-timetable out of GCT/Penn seem to be the magic mark for Manhattan), the crazy house prices go away and you can still get pretty reasonably priced real estate.

Coastal hubs like SF, Seattle, and NY seem to be pretty much immune from the real estate/financial markets. Short of an asteroid or an entire industry becoming obsolete, those RE markets will never change.  My hometown and possible FIRE location is within commuting distance of SF. It's always been CA suburbia, but in the last decade the Bay Area's "commuting range" has extended to include my home which is 2 hours away in good traffic.  A lot of people I grew up with are being priced out of our hometown and are moving out of CA, often taking their income with them to Portland, Phoenix, Austin, or Boise. If after the COVID dust settles a number of those Bay Area employers decide to expand WFH opportunities with the same pay, those RE markets are going to be insane, especially if there are a number of sell-offs/evictions/foreclosures.

FYI, a nice NYT upshot article on this topic:
https://www.nytimes.com/2021/01/04/upshot/work-office-from-home.html

ChpBstrd

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The evictions will start as soon as they can start. I think a lot of landlords, especially new ones, will want out of the game. Others will be foreclosed out of the game. It might be a good time to get into RE, particularly urban RE, but the valuations in coastal markets are still insane. A rise in interest rates could bring them down, but that's not happening as I explained above. I'd say pick up REITs or leveraged RE in LCOL areas, but don't pay $2M for a coastal property that nets $250/mo when all goes well.

I *think* there is a possibility that corporations will start opening up more satellite offices in far out suburbs near the large city. For the part of work that can't be WFH, social distancing will likely need to be baked into the new office space guidelines even after the pandemic is over. That would make Manhattan/SF/Boston real estate way too expensive. With nearby satellite offices, you preserve the flexibility to have people come over to Manhattan for meetings, but still pay a fraction (less than a tenth in many cases, I was told) for the office space.

We will know if this is happening or not by the beginning of 2022. If it does start, then several of these far out "exurb" areas could likely become very interesting for RE investment. Once you go out of the commute range (75 minutes by the train-timetable out of GCT/Penn seem to be the magic mark for Manhattan), the crazy house prices go away and you can still get pretty reasonably priced real estate.

Coastal hubs like SF, Seattle, and NY seem to be pretty much immune from the real estate/financial markets. Short of an asteroid or an entire industry becoming obsolete, those RE markets will never change.  My hometown and possible FIRE location is within commuting distance of SF. It's always been CA suburbia, but in the last decade the Bay Area's "commuting range" has extended to include my home which is 2 hours away in good traffic.  A lot of people I grew up with are being priced out of our hometown and are moving out of CA, often taking their income with them to Portland, Phoenix, Austin, or Boise. If after the COVID dust settles a number of those Bay Area employers decide to expand WFH opportunities with the same pay, those RE markets are going to be insane, especially if there are a number of sell-offs/evictions/foreclosures.

FYI, a nice NYT upshot article on this topic:
https://www.nytimes.com/2021/01/04/upshot/work-office-from-home.html

Kinda weird how the author of the NYT article notes an earlier trend toward decentralization of headquarters, current trends of happy and productive employees working from home, insane real estate costs, and the imperative to find talent wherever it is located --- and then concludes "total demand for offices will diminish to a moderate degree."

How about a large degree?  The whole white-collar work culture is changing toward WFH via the internet, and there is good reason to believe this is the lowest-cost way of doing business. My company went to 95% WFH last year, costs dropped, productivity was fine, business doubled... why go back? The author says "Most office activity will not move to homes or to the cloud." but we're thriving at 100% right now with current technology and bandwidth. All that empty retail space that Walmart and Amazon have made obsolete will soon be going on the market as office space too. Supply is increasing just as demand is decreasing, and there's only so much "repurposing" that can absorb this tide change.

I would not want to own an office or retail REIT right now, but I might also advise against urban property in general. Urbanism is cyclical, with 3-decade cycles of decline and renewal. The last cycle of renewal lasted from about 1990 to 2019. Prior to that a period of decline from about 1960 to about 1990 was driven by car culture and a shift to suburbs/exurbs. A bit of rising crime/poverty and rising vacancies in commercial properties would seal the deal on another 30 year cycle of urban decline, this time driven by Microsoft Teams, Salesforce, Google applications, Zoom, FaceTime, etc. It may be time to move to a small town with good bandwidth and cheap real estate, and I say this as a person living in an urban environment.