Rate Hikes Will Expose Problems

Is today the Big One?

With apologies to the late Redd Foxx and his hilarious, “It’s the big one, Elizabeth, I’m comin’ to see you” routine, the Fed is due to give us a little more clarity on when the first interest rate hike will come. 

Yes, it’s a big one. 

Because the stock market has gotten way too comfortable with zero interest rates… because investors are too comfortable with the notion that U.S. interest rates will never rise… because global economic data is just not very good right now…

Some commentators aren’t very worried about rising interest rates. It’s the sign of a stronger economy, they say. There’s a bubble in Treasury bonds that needs to be tempered, they observe.

If you check the anecdotal data, you’ll find that stocks typically do pretty well when interest rates rise.

Sure, the few weeks after the first interest rate hikes usually comes with falling stock prices. But look a few months out, and stocks tend to do pretty well, as this graphic shows:

And the reasons stocks tend to do pretty well when interest rates rise is because the economy really is improving.

From that perspective, maybe we should welcome a hawkish Fed that’s ready to charge a bit for lending money…

But I’m not so sure. I think rising interest rates could actually prompt investors to start staggering around, right arm clutched to their heart, left arm waving wildly, declaring, “It’s the Big One!”

Here’s why…

Addicted to Debt

Interest rates have been at zero since 2009. Six years. That’s a ridiculously long time for rates to stay at emergency.

It’s not an emergency anymore. Now, low rates are written into people’s valuation formulas. Low rates are used as justification of high P/E ratios.

Investors say, “Yes, P/E ratios are high, but you have to look at them in the context of low interest rates.”

I’m still not exactly sure what this means. Are investors willing to pay more for stocks that pay dividends because Treasury bond yields are so low? Or is it meant to suggest that companies are earning more because borrowing costs are low?

I suppose you could say it’s both — though each excuse has a problem, not the least of which is that the zero interest rate situation is temporary. Bonds won’t always yield so little. At some point, yields will rise, and bonds will become competition for dividend stocks. 

Borrowing costs will not stay this low, either. They can’t. The Fed will hike rates. It’s just a question of when…

If you exclude the Internet bubble, the S&P 500 is as expensive as it’s been in 40 years. To me, this is a clear sign that zero interest rates are no longer an extenuating circumstance. They are a given, a fundamental data point.

That’s not good.

Do You Feel Lucky?

Some people will tell you zero interest rates can stick around because they haven’t created any “imbalances” or bubbles at this point.

This is not true. Zero interest rates have created two bubbles that I can see plainly…

The shale oil revolution was built on zero interest rates. Over the last five years, oil companies raised $500 billion because rates have been so low that investors bought up oil bonds without worrying about it.

This money funded a massive drilling expansion that helped push the global oil market into oversupply. Oil prices crashed, and now these oil companies are really struggling. They are taking on even more debt to pay off the debt they already have.

If oil prices don’t turn around, many of these companies will go bankrupt. And because they have to keep pumping oil to pay the bills, the oil market may well stay oversupplied for quite a while.

The other bubble is the company stock buyback bubble. And it is much more subtle.

S&P 500 companies have spent ~$4 trillion on share buybacks in the last few years. And they may buy another ~$900 billion this year. When a company buys back shares, it is lowering the number of shares outstanding. That, in turn, makes earnings per share (EPS) rise because you’re dividing the total earnings by a smaller number.  

This isn’t as powerful as dividend hikes, which return money directly to shareholders. Still, buybacks can make a stock’s valuation more attractive in the short term…

The problem right now is that earnings per share (EPS) are showing small improvement. Something like 70% of companies are beating first quarter earnings expectations. But revenue isn’t rising. 50% of the S&P 500 is missing revenue expectations.

In other words, much of the earnings growth we are seeing isn’t due to an improved economy — it’s simply the result of companies having fewer shares outstanding.

The Buyback Bubble

Consider the case of Panera Bread (NASDAQ: PNRA). Panera has bought back 3 million shares since 2012. And earnings per share has risen by one penny.

Panera reported $1.40 in earnings for the second quarter of 2012. It just reported $1.41 for the first quarter of 2015.

It should be clear that if Panera hadn’t been buying back stock, its earnings would be around 10% lower than they actually are. And that P/E would be nowhere near the current 27. Investors are pricing stocks for growth when they really aren’t growing as fast as it appears.

When interest rates rise, companies will not buy back as many shares because they are using debt to do it. That will shine a spotlight on the lack of revenue growth.

So today’s Fed announcement concerning interest rates is a big one…

First quarter GDP came in at an anemic 0.2% gain over last year. And don’t forget, last year’s first quarter GDP was a decline of 0.1% because of the polar vortex. Growth is simply not good.

Of course, growth could pick up. That’s what investors and economists are betting on. And they’re betting the Fed won’t hike rates with anemic GDP growth.

But the way I see it, we either have a weak economy or higher rates, neither of which is good for stock prices.

So be careful with new stock purchases. Stick to sectors that have growth, like renewables, certain tech stocks, and health care.

You might even get prepared to sell some covered calls against your long-term holdings to raise some cash when the time is right.

You don’t want to get caught by surprise when the big one hits.

Until next time,

Until next time,

Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.