The Fed's Fun House

Written By Briton Ryle

Posted June 22, 2015

Did you hear what Fed Chief Janet Yellen said last week?

Well, if you missed the statement after the latest Fed meeting, I’m here to pass it along… because the Fed’s latest explanation of interest rate policy is by far the most important information we’ve gotten from the Fed in a long time.

You need to know what was said — and more importantly, what it means — because last week’s Fed statement is going to dictate the course of stock prices for the rest of this year and probably much of next year, too.

It’s too bad the stock market has come to rely so heavily on the Fed. I liked it much better when you could parse the economic data, get a feel for economic and earnings trends, and come away with a pretty good idea of what was ahead for stock prices.

But that all ended in 2009, when interest rates were cut to zero and the Fed guaranteed a couple trillion dollars’ worth of debt held by companies teetering on the brink of bankruptcy.

They say you shouldn’t jump in the water to save a drowning person because that person will be so desperate that he will grab you in an attempt to save himself, preventing you from helping. Then you both get dragged down.

But that’s exactly what the Fed did. It jumped in the water to save the drowning banks and other companies. It lent them money, guaranteed their debt, and cut rates so they could borrow even more money on the cheap. The Fed went “all in.” And that meant if these companies went down, the Fed would go down, too. 

So the Fed has had to do some pretty radical things to make sure troubled companies stayed afloat. First, it assured us that interest rates would stay low for years. This way, companies could continue to borrow money as cheaply as possible, thereby making their balance sheets as strong as possible.

But that’s just one way interest rates help companies and stock prices. The other ways are more insidious…

The Fed’s Hall of Mirrors

The Fed’s zero interest rate policy has created a hall of mirrors like you’d find at a carnival fun house.

When you see yourself in a fun house mirror, you can still recognize your features. But your reflection will also be distorted to comedic and grotesque extremes. Your head may look tiny while your legs look 10 feet long, or maybe your whole body looks thin as a pencil.

Zero interest rates distort what we see of the economy and the stock market in much the same way.

For starters, low interest rates push people into the stock market. If you’re a conservative investor, you may not want to own stock. But when the interest income you are receiving from bond investments isn’t even beating inflation, you may have no choice but to accept more risk and go after stocks.

When stocks rally, analysts and economists often presume investors see anecdotal evidence of an improving economy that hasn’t really shown up in the data. This is what is meant when you hear that the stock market is the ultimate discounting mechanism. The stock market changes prices based on expectations about the future every day.

So higher stock prices that reflect an improving economy are one thing. But higher stock prices based simply on investors’ needs for better yield is quite another. Which fun house mirror are we looking at today?

Low interest rates distort the economic reflection in many other ways. For instance, let’s suppose you are a conservative investor that refuses to enter the stock market. You may have to cut your personal spending to make up for the loss in interest income.

Less spending then makes the economy look worse than it is. And as it happens, economists are still wondering why spending hasn’t improved…

To further distort the picture, companies are borrowing money at low interest rates and using it to buy back their own shares. As they lower the number of shares outstanding, their quarterly earnings per share automatically rises and price-to-earnings (P/E) ratios fall.

Rising earnings per share makes it look like companies are making more profits than they actually are. And falling P/E ratios make stocks look cheaper than they actually are.

So What Are We REALLY Looking At?

This is the big problem: Because of zero interest rates, we don’t really know what we’re looking at. Economic growth and stock valuations are being affected in ways we don’t fully understand.

And to make matters worse, investors have started to just assume that low interest rates are a permanent fixture when calculating growth and valuations.

But of course, it’s impossible to keep interest rates at zero forever. At some point, all these assumptions about our zero interest rate world have to change. And then what will we be looking at in the fun house mirror?

That’s why the Fed’s policy statement last week is so important. We’ve all known interest rates will start rising soon, probably this year. What we haven’t known is how high they will go. So last week, Janet Yellen told us the answer…

Interest rates aren’t going a lot higher anytime soon. A quarter-point hike or two this year, a few next year… but Janet Yellen came right out and said interest rates would not be above 3% at the end of 2017.

So it looks like we will get to hang out in the fun house for a couple more years. Get ready — stock prices are going higher.

Until next time,

Until next time,

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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.

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