Interest Rate Party May Be Ending Soon

April 17, 2015

Current predictions are Canadian prime interest rates could be at 4.75% within two years.  But Canada may lower them again before raising them!

The short term potential decrease in Canadian rates notwithstanding, Canada will follow (likely lag) the US in their interest rate policy. The US Federal Reserve recently indicated they are going to be bringing an end to the near zero percent interest rate policy.  If they do, Canada must raise rates too.  Predictions suggest an increase of 1.75% over the next two years.  Immediate impact on equity markets could be increases in volatility and potentially temporary declines.  Interest rates are not the only factor in what markets do over the short term – global events, consumer spending patterns and of course the profitability of businesses are all factors.

Equity Funds have done well in the higher interest rate environment of the 80’s and 90’s and when it comes to business success, it’s not so much the cost of money (lending rate) as it is the access to money from lending institutions.  Businesses need access to borrowed money to expand.  As long as businesses continue to be profitable lending institutions will provide them money!

So my short term answer is no, I’m not worried about interest rates increasing.  Long term historical probability suggests, a diversified portfolio, properly managed and with sufficient cash for short term income and emergencies will do just fine.

Fed Ready to End the Party

Is the Economy Ever Completely Unstable?

Understanding the difference between market price and the true value of a business is the key to success in long term investing and economic instability is may only be in the mind of the financial journalist.  Let’s examine this by considering, “Would you ever stop wanting to buy toothpaste?”

The content for this article is summarized from an article by Nick Murray so I can’t and won’t take credit for this explanation – I’ll just try to keep it brief!

Toothpaste along with financial services, shipping of goods, car insurance, groceries, manufacturing and distribution of computers, cleaning supplies etc. are all products we purchase regularly regardless what the economy does. How much we purchase may vary but never that we will purchase. These services and products are provided to us by some of the best managed businesses on the plant – many of which are considered US companies despite operating globally.

Given the US is one of the largest economies on the planet,  consider that the market capitalization (share price times shares outstanding) of the 500 companies included in the S&P 500 market index is about $19.5 trillion.  That’s a big number and a real lot of money.

The US National Bureau of Economic Research reported that the US Gross Domestic Product – value of all goods and services produced in the US in 2014 was $17.7 Trillion.

Therefore, the price the stock market currently places on all the S&P 500 public companies in the US exceeds by a considerable margin the value of all goods and services produced in the US all of last year. ($19.5 trillion market cap vs $17.7 Trillion GDP)

So the story goes, when the market price of public companies declines – and it does often – this price decline somehow impacts the economy directly creating this notion of fragility and instability.

But consider this, when the Great Recession of 2007 to 2009 occurred, the US economy (and Canada) experienced a 4.3% decline in GDP.  During this recession, even the strongest companies suffered significant declines (however briefly) in their earnings and dividends and in their value of businesses but – note this – the prices of their stocks declined peak to trough a staggering 57%.

So – the equity price declines (57%) were hugely disproportionate to the long term impairment (if any) and the contraction of the economy as a whole (4.3% GDP decline).

I hope you can conclude that an economy producing close to $18 trillion of annual goods and services, with a depth and diversification of businesses selling all manner of goods we will continue to need and want (i.e. toothpaste) with share value of $19.5 trillion (in a rational market) could really be unstable?

Collectively, the economy is made up of a vast number of diversified and rationally managed businesses which will continue providing goods and services the world will demand.  Occasionally the fear and/or greed (which are always present) overcomes and disrupts the market prices of these well managed and valuable companies.  Those that understand these situations are temporary and simply part of the market process but never disrupt the long term value of these businesses will succeed as long term investors.

What is Risk?

The following is a recent quote by Warren Buffet from a meeting he had with MBA students just last February.  When Buffet speaks, I listen.  He provides his definition of risk with respect to stocks.

“With regards to risk, the Berkshire portfolio suffered a 2% loss once and had 1% losses twice in our history. This was all in 1974 and 1975 when we sold assets cheap to buy other assets cheaper. Stocks are riskless if held over a long time frame as you are simply giving up purchasing power now for later. Cash is the risky asset. Risk in stocks is not what the companies will do. Traditional finance teaches that Beta is a measure of risk but volatility isn’t risk. Risk is loss of purchasing power. Volatility declines over a long enough timeframe. It is individuals that make investments risky. In our report that is due out tomorrow I talk about how risk needs to be rethought. People think stocks are riskier than bonds, which is not true for a long time horizon.”   Warren Buffet

The best investments in the world can provide terrible returns if the investor doesn’t know what he/she is doing.  Here’s the definition of risk I like, which applies to doing anything in life:

Risk is not knowing what you’re doing!