Low Interest Making Stock Attractive

June 9, 2003
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GRAND RAPIDS — More discipline, less emotion and a clear focus on long-term goals can do an investor good.

So said Timothy Swanson, chief investment officer for National City Wealth Management, at an investment seminar last week at the Amway Grand Hotel.

Right now stocks are expensive relative to their longer-term history, but cheap relative to bonds, he said.

“We would argue that stocks are a pretty attractive value today, particularly relative to fixed income instruments,” said Swanson, who oversees investment management for the Private Client Group, which has nearly $30 billion in assets under management. “For that reason we’ve been advocating a somewhat overweighed position to stocks and, on the flip side, an under weighted position to fixed income.

The current yield on a 10-year treasury note is 3.3 percent. In the early 1980s, the yield was in the mid to upper teens.

Falling interest rates are good for holders of fixed income instruments as securities appreciate, Swanson said, but if they reach maturity in a low interest rate environment and are reinvested, low interest rates adversely affect yields.

He noted that fixed income investors have seen an 80 percent reduction in income over the past 20 years as interest rates have fallen.

“This is something a lot of people have forgotten. People haven’t looked at the historic returns of fixed income and the historic returns of stocks, particularly very recently. They come to the conclusion that you make a lot more money in bonds than in stocks. That’s been true for the past three to five years or so.

“But the important thing to remember is that when you invest in fixed incomes today, you’re not investing at the rates that existed five, 10 or 20 years ago. A lot of people who are looking purely at the returns they have gotten are making incorrect judgments about the future because they don’t understand the historical factors.”

How low can money market rates go? Pretty close to zero, he said. Recent comments from the Federal Reserve hint at the possibility the Fed may lower the federal funds rate again when its meets later this month.

The current yield on a two-year treasury is actually trading below the federal funds target rate of 1.25 percent, Swanson pointed out. So it’s likely that all those investors who were counting on their money market portfolio to compound rates of return are going to have to wait longer to get rich, he said.

Interest rates will stay low for a while, Swanson predicted, but how low can they go and for how long?

There is some historic precedent for rates to stay very low for a period of time, he said. Japan, which is now in a deflationary period, had very low rates for a very long time, but Swanson doesn’t think deflation is likely here. If it starts to head in that direction, the Fed has the tools to ensure it doesn’t go that route, he noted.

In the free market, prices adjust so that sellers and buyers are in equal proportion. When information is widely known and understood, the market has already adjusted and the information is reflected in prices, Swanson explained. The same is true for the stock market.

“So whenever you hear somebody that has a great tip based on something he read in the newspaper yesterday, you ought to think twice about that because once information is in the public domain, and everyone views it the same way, the value of that information goes down.”

There’s a fairly high correlation between investor sentiment and what the markets do and that correlation is negative, Swanson observed. When investors as a whole are bullish, stocks tend to under-perform. When investors as a group are bearish, stocks tend to outperform.

Why would investors be bullish? Because times are good, the economy is rolling along, people are optimistic and everybody’s happy, Swanson said.

“With that kind of environment going, that information is already reflected in the value of stocks, and when a very optimistic scenario is already reflected in prices, you’ve already built in very high expectations and the odds are you’re going to be disappointed.”

The flip side is that when everyone is bearish, no one wants to buy stocks. That’s because there’s a very negative view when times are bad and it’s that view of the world that’s already being reflected in the prices of stock, he explained.

How does an investor generate good returns?

Swanson said the best strategy is to develop a game plan based on long-term goals and analysis and to follow a disciplined process that focuses on finding ideas not fully appreciated by the market.

Investors as a whole are myopic; most of them tend to use a magnifying glass rather than a telescope, so it’s hard for them to look out to the future, he said. Many investors tend to react too emotionally, as well.

He likened investing in stocks to getting on an airplane: An investor needs to know where he’s headed and he has to have an emergency exit strategy.

As Swanson put it: “Identify what the risks are and develop a plan to monitor those risks so you can get out while you’re still alive.”

Stocks have benefited more from the tax law change.

With the new tax law changes, dividends are now treated like long-term capital gains and the maximum rate on long-term capital gains has fallen, Swanson observed.

“If you are an investor who pays taxes on your portfolio, you should favor stocks more today than you used to as a result of this tax law.”

The after-tax rate of return on stocks has gone up meaningfully as the result of the tax law, he said, and the tax rate on dividends for upper income investors has fallen from 38.6 to 15 percent.

“Taxes are down, meaning after-tax returns are up. Stocks have benefited more than any other asset class from the tax law changes. Within your overall portfolio, you should have some of your money in taxable accounts and some of your money in tax-deferred accounts. Tax laws give maximum benefit to stockholders that are long term, so shift as much of that as you can into your taxable account.”           

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