It is a universal law of wealth, that money goes where it is treated best in terms of both return and safety. If you have a million dollars to deposit and two banks in your town - one paying 5%, and one paying 6% - which one gets your million? Of course, the 6% is a no-brainer. Not only does the money go where it is treated best within the context of bank deposits, but it is also true across asset classes. The various asset classes (stocks, bonds, real estate, crypto, commodities, etc) are constantly vying for investment dollars by offering varying degrees of risk and return. As a general rule, safer investments have lower returns (think bonds), while riskier investments can yield larger returns (think crypto). While each of these asset classes has various plusses and minuses, at the end of the day, they are all governed by prevailing interest rates.
BONDS:
Bonds are the easiest to understand with regard to interest rates, so we will start there. When you buy a bond, only two things matter. How long is the money locked up, and what is the interest rate. The interest rate determines the income the bond produces. For example, with interest rates currently at 2.5%, putting $1,000 into a 30 treasury will earn you $25/yr for the next 30 years, and then you get your $1,000 back as well.
Let’s say interest rates head back to historical norms of 8%. A new bond buyer would only have to put up $312.50 to earn the same yearly income of $25 ($312.50 x .08 = $25). Sounds ok, except from the perspective of the guy who put up the $1,000 to get the $25. That guy is locked in for 30 years, and if he wanted to liquidate, and get his principal back - he would only get the $312.50, not the $1,000 he put up - almost a 70% loss.
Bonds are the biggest, deepest market on the planet; nothing else is even close. There are retirees, hedge funds, governments, pension plans, 401k’s, etc… who are all in the same position as the hypothetical guy above who put up the $1,000. When interest rates go to 8%, all of those folks will be losing 70% of their principal, no exceptions. Stated another way, rising interest rates will absolutely crush bonds, just like they did in 1980. Due to the sheer size of the bond market, the bloodbath will be Tarantino-esque.
STOCKS:
Now let’s consider stocks. With normal interest rates of 6-8%, the price-to-earnings ratio (PE) on stocks has historically been in the 12-16 range. The reason is, that if you put a dollar in the bank, you get 6-8 cents in interest after a year. Put that same dollar in a stock with a PE of 12-16, it will earn a little over that 6-8 cents ($1.00 / 16 = 6.67 cents, or $1.00 / 12 = 8.5 cents, plus dividends). In other words, you get marginally more return on your $1.00 in exchange for accepting the additional risk owning stocks brings over parking the dollar in the bank.
With prevailing interest rates on bonds currently plumbing historical lows, you would expect capital to pour into the stock market looking for better returns, and driving up the average PE in the process. Today, parking a dollar in a bond gets you 2.5 cents. With those paltry returns, you are mathematically better off to buy stocks with a PE as high as 33, earning you a higher return of 3 cents per dollar (plus dividends)…. $1.00 / 33 = 3 cents. This is precisely what we see today, with the average PE on the Nasdaq at 31 and the S&P at 26. Both are well above historical norms, specifically because interest rates are bouncing along generational lows.
Let’s consider what happens as interest rates approach 14%, as they did in the early 1980s. If parking a dollar in the bank earns you 14 cents, you would expect to find the prevailing PE of stocks at 6-7…..$1.00 / 6 = 16.6 cents return & $1.00 / 7 = 14.3 cents return (plus dividends). Wouldn't you know it - the PE on both the Dow and the S&P averaged about 7 in 1980. If interest rates get back to 14%, and earnings stay at the levels they are at today (which is very optimistic as high-interest rates crimp earnings), you can expect to see the S&P at about 1100, and the Nasdaq at about 3100 - about 80% off from today’s levels. This paragraph & the previous two affirm the old adage of "when interest rates are high, stocks will die, and when interest rates are low, stocks will grow.”
REAL ESTATE:
While stock prices are a function of interest rates AND earnings, real estate is a direct function of interest rates AND the income the property can generate. Consider houses here in my home city of Phoenix, where the median home is 400k, and the average rent is just under 2k. You can put the 400k in treasuries and get roughly 9k/year....or you could become a landlord and get 12 months x 2k = 24k year; less property tax, insurance, and maintenance - which, if it stays rented all year, would net you about 18k/year. That's about twice the return of sticking it in the bank, which seems fair considering the work involved being a landlord. The extra return on capital explains the strong bid on real estate today.
The real question is, what is a fair price for that same median house if interest rates went back to the historical average of 8%? Under this scenario, 400k in the bank at 8% would earn 32k/year. In order for the 400k house to stay valued at 400k, the rent would have to double for the property to net something more than the 32k/year a bank deposit would offer. There is a second possibility, the price of the home could get cut in half. The guy with 400k could then buy 2 properties for 200k each, netting 2 x 18k = 36k/year. But, absent a doubling in rent or a halving in price, capital would flee the real estate market in favor of the guaranteed return of a savings account.
Perhaps, we would get some of both…
Consider a 25% decrease in the price of the house coupled with a 25% increase in the rent; this would leave the home priced at 300k, grossing 30k/year in rent, and netting about 24K. A 300k investment by a landlord netting about 24k is exactly equal to the 8.0% return offered by the banks in our hypothetical scenario. Meaning rents would have to increase more than the 25% AND prices would have to fall more than the 25% to adequately compensate landlords for their work and their risk. Scary thought indeed. More alarming is where real estate prices would be if interest rates ever approached the 14% we saw in the early 1980s. Bagholder will save you the math and cut to the chase…You could expect to see housing prices cut in half AND rents double.
CRYPTO:
It is well known, that higher interest rates generally mean a lower appetite for high-risk/high-return assets, such as cryptocurrencies. As rates rise, borrowing costs increase, making capital more precious and less open to risk. Old fashioned savings accounts, offering higher returns as rates rise, will entice some of the capital to leave the crypto market in favor of an ever-increasing guaranteed return. This is exactly what we are seeing today. Since the Fed started raising rates in January of this year, Bitcoin & Ethereum are both off over 35%.
It is difficult to quantify the effect higher interest rates going forward will have on the crypto market, because Bagholder struggles to comprehend why crypto has any value at all. Then again, Bagholder never understood the rising prices in Beanie Babies or POGS. It may just be as simple as recognizing when the feds raise rates; it leads to the reining in of liquidity in the investment markets. Less liquidity means less demand for risk and consequently less demand for crypto. Higher rates will be a strong headwind for crypto any way you look at it.
COMMODITIES:
Now let’s consider Commodities. They are a direct function of interest rates AND inflation rates. Producing Commodities (Oil, Gold, Wheat, etc…) is a capital-intensive, expensive proposition. It doesn’t matter what the commodity is; with labor costs, permits, machinery, etc... they are all spendy to produce. Because of all the expenses, commodity producers have to borrow money to finance their mines, wells, or farms, which adds interest expense to the cost of production. With today’s low rates, the interest expense is small, enabling the production of the given commodity for the lowest possible cost.
Along comes inflation, which brings with it higher and higher prices for all kinds of things, especially commodities. Looking back at the last time inflation was raging (1970s), commodities were the best place to have invested money. Not only does inflation drive the commodity prices higher, but inflation brings with it rising interest rates. This adds to the borrowing costs of the producers. In fact, for many of them, the interest on their debt will become their biggest expense. This will put many of them out of business, further constricting supply, and accelerating the already sharply rising prices.
Once interest rates rise to a level that exceeds the inflation rates, producers will be in a position where their expenses will be going up faster than they can raise prices. This is what killed the commodity bull market of the 1970s. The Fed raised interest rates above the prevailing inflation rates, and capital left the commodity sector to go where it was treated better: locking up 15% returns in bonds for decades. Provided interest rates stay below the inflation rate, commodities will do well - but when interest rates are higher than inflation rates, commodity investors too will be in trouble.
CONCLUSION:
An environment where inflation continues to rage will put pressure on all asset markets, except commodities. Now that we have double digit inflation, commodities will continue to accelerate higher in price until the FED raises interest rates ABOVE the rate of inflation. When they finally do that, we will have the double digit interest rates scenarios listed above. Stocks, bonds, crypto, and real estate will all be holding 50-90% off sales, thanks to those double digit interest rates. The question becomes, how do we take advantage of this? Bagholder’s best guess is:
Commodities are a no-brainer
Short Stocks (buy deep out of the money calls as insurance)
Short Bonds
Get yourself a 30-year mortgage and recognize the mortgage is the asset, not the property you have it on.
Buy farmland on which you can produce your own food (commodities)
Mrs. Bag and myself are headed out on a little vacation, should have my next post up in a couple weeks…. Until then Bagholder recommends you check out one of my best columns ever, written last summer, and is grossly under viewed…
“In the street of the blind, the one eyed man is called the Guiding Light.”
We have all heard this saying, in one form or another. What I have learned from this saying is that people are imperfect. It says that even the most perfect of people aren't perfect.
I see this applied today in our monetary systems and how one currency above all, can appear to be better than all of the others. Although this currency does appear to be better, we all know that perfection is only skin deep. As time passes on, perfection tends to show its inner failings, revealed as imperfections, which manifest into cosmetic fixes, meant to deceive the onlooker.
Cracks and lines begin to appear, yet the overall beauty of that perfection remains intact...until one exposes the methods used to maintain that perfection. The natural beauty is shadowed by the methods used to "makeup" for time.
We are no longer in the land of the guiding light. Perfection no more. When perception morphs into reality, because appearances/perception have a greater influence on the minds of people, than the damn facts presented by reality, you know the gig is up.
Excellent and concise article. I’d say even a caveman could understand it, but history shows that not true.