The Practical Economist

INVESTMENT OUTLOOK - July 10, 2017

Investment Outlook

If you're new to how The Practical Economist evaluates investment opportunities, we strongly recommend that you skip to the section below, first, in which we lay out our philosophy,

We left the most recent column updated for so long because we believe very strongly that our theory about how long-term interest rates are likely to behave for the next two to four years is compelling.

As we put it, there are few investing puzzles you cannot solve if you can decipher the timing and directionality of long-term interest rates.

For this column we are going to touch on a related topic: short-term interest rates.

One of the most interesting things to watch for is the gap between where long-term interest rates are and where short-term interest rates are.  It's interesting precisely because while the former is partly informed by the latter, while the latter is controlled by the central bank, the latter is a market response.  There is a great deal that can be gleaned from watching the divergence of the two. 

Let's keep this ridiculously simple.

It is our thesis that there is such a thing as a normal band in which that yield curve should be in order for the market to remain in equilibrium.  When that curve is too small, short-term rates are irrationally high, and when that curve is too large (or too high, if you will), short-term rates are irrationally low. 

It is also our thesis that the central bank has a pattern of grossly overreacting to conditions, usually a function of having not acted soon enough to adapt to a changing economy.  Thus, even as the Fed encourages the fostering of an environment of domestic investment, it also frequently brings on over-heating.

When you think about what that normal range is, you should think about a band that stretches from 1.25% to 0.75%.  While venturing outside that band for a short time is not meaningful, any sustained sojourns beyond that are very meaningful and should be noted as warnings.

We strongly encourage you to do the research yourself and see the patterns yourself.  We do not intend to make this column dry enough as to discourage readers.

In this regard, you should not be too surprised that the Fed has moved to raise interest rates moderately twice in the last six months.  In the 18 months after the Fed eliminated its bond-buying program and before it started to gently raise rates, you will do the arithmetic and observe that that curve was in a band that was unsustainably high.

All of this is part of the long way of communicating that, especially since the Fed began raising short-term interest rates nine months ago, that yield curve band is...sitting in a comfortable zone.  Yes, it has been hovering on the high side of where that band should lie, but...fundamentally it's sound.

Practically, what does that mean?  It means that, you don't have a lot to fear with regard to the interest rate environment creating unsustainable asset bubbles.  This point is underlined by our recent statements that, while the ratio of earnings to debt in the private sector has been coming under a little pressure, (1) it's only modest pressure at present and (2) earnings relative to debt have actually been growing.

A few takeaways:

1.  No, all of this does not mean that the stock market is not overvalued.  What it means is that a wholesale collapse in the market is going to become of a remote possibility and that you should, if anything expect the market to move sideways in the near term.

2.  This does not negate our forecast that the economy will continue a significant softening through 2017 and most of 2018.  A softening is not the same thing as a contraction and if anything can be equated with keeping the economy from over-heating.

Did we cover enough ground for this update?  We think so. 

 

The Practical Economist's Investment Philosophy

Perhaps the most fundamental cornerstone to the philosophy of The Practical Economist is the concept of maximizing opportunity for return.   Every time that you squeeze your opportunity for yield, you are either minimizing return opportunity or maximizing risk or...both.

The classic way you minimize risk is to eschew and sell an investment that is hitting new highs...in concert with fundamental indicators that do not suggest a landscape of strong growth.

And the classic way you maximize opportunity is to embrace investment classes that have not just experienced corrections but are so out of favor as to be considered in the figurative basement.

Again, our fundamental indicators about the economy must support what the rest of the data suggests, i.e., just because an equity market index has fallen 50% off its high that's not sufficient unless the economic landscape suggests, at minimum, that economic slippage has come to a standstill.

A combination of the two--severely out of favor investment class and at worst a neutral economic landscape?  That's what The Practical Economist needs to see, and when it exists we will tell you about it.