Last night, the comparison came up with recent selloff action and 1987. But the more frequent relative comparison from the perma-Bullish camp is 1994. That’s the year that gives some folk — most notably, Don Hayes and James Cramer — comfort in the belief that the market is safe from a major correction at this time.
Ryan Fischer destroys that argument. I thought his observations on this frequent Bullish comparo between 1994 and today were very astute. Since he does not publish anywhere else — and I liked his piece a great deal — I offered Ryan the Big Picture as a platform to publish this.
As always, feel free to comment . . .
Dear God, Please stop
talking about 1994-95
The Winds of Cost of Capital
By Ryan Fischer, 5-20-06
Please, please, I beg of you: quit talking about 1994-995.
2006-07 has no similarities whatsoever — except in your hope.
remember what the bond market did in 94-95? Anyone? The yield on 10 yr
treasuries went from basically 5.5% at the beginning of 94 to 8% by year end.
That being the number the bond market erroneously thought the FED would go to.
By the end of 1995 the yield on the 10 yr was back at 5.5% a dramatic easing of financial conditions. And, on cue, assets went wild, housing and consumption caught the wind in their sails
coming off the bond market and off Risk ran.
Consider: For us to
experience the same winds of easing of financial costs today yields on 10 year Treasuries (currently 5-5.2%) would have to decline to 3.5-3.7%. What kind of
macro environment would we be in if 10 year Treasuries were yielding 3.5-3.7% six
to twelve months from now? Hello deflationary soup!! That or some crisis that
has convinced Helicopter Ben to deploy the "Unconventional Measures" he talked
and wrote about during his emergence. Friends, if the Fed is buying 10 year
Treasuries and causing a 3.5-3.7% yield we might as well take the stars off our
flag and replace them with a hammer and sickle.
A forewarning: Whenever you
hear or read about Unconventional Measures from the Fed or the Treasury think
State Interference in Free Markets. And we all know where that leads and ends.
But, I digress, as
this missive is primarily about the cost of capital, its percentage change and
the effect that has on risk assets.
Whenever you hear
someone mention historically low interest rates while supporting their bullish argument for whatever risk asset they are
buying, holding or selling, immediately mark them down in your book as
financially illiterate. (Note, this argument is often heard from the CEOs of
public builders, their real estate brethren and the sheep who follow, plus
Let me say this: It
is not the absolute level of the rate of interest that matters to those who
allocate capital, it is the relative rate of change.
Let me elaborate: Everyone likes to
pull the grandpa "I remember 15% interest rates in 1982, so 5% today is really
historically nothing to be afraid of" (Again note; This is another favorite of
anyone selling, holding or pushing real estate). Lets think about that
intellectual construct for a second and see if, as a person who allocates
capital, if it would sway where I push my dollars.
rates were around 12-15% in 82-84 and today they float around 5-5.2% (ten year Treasury yields on both) I therefore should be more willing to employ my capital
in risky assets because money is so much cheaper today than some 22-24 years
First, let me say I will not even touch on the subject of
valuation, though the argument about then vs. now should be clear to any open seeing eyes.
Rather, let us focus on the cost of capital. As a
speculator, entrepreneur, investor, etc..etc..those absolute levels mean
nothing to me. For all I care, interest rates could have been 80% in 82 and the
argument about historically low interest rates today still will not sway me. In
fact, I’ll tell you I’m more excited about a 10%, 9%, or a 8% rate of interest in
85, 86 and 87 than I am about a 5% rate of interest in 2006.
Its obvious, isnt it? 16% in 82 to 9% in 85 is a huge, huge
tailwind at the sails of risk assets. This is a dramatic easing of financial
conditions. Also, trust that asset prices failed miserably for many, many years
to reflect this change. Such are the effects of psychology and the enhancing
fruits of under-valuation. The world is nearly without clouds when interest
rates fall so dramatically (kind of like 2000-2003). Is the world equally not
dark vs. 85(15% in 82 to 9% in 85) or as sunny as 94/95 (again, 8% to 5.5%) now
that rates have gone form 1% to 5% on the short end and 3.5% to 5-5.2% on the
Based on the cost of
capital, when are you a buyer? When interest rates decline by 40% (15% to 9%) or
increase by 45% (3.5% to 5.07%)?
To risk assets, the
cost of capital is like the wind. It is the change from the start of the race
that matters, the more headwind the more trouble, and the more wind one can
summon to their back, the faster the ship sails.
God what I would give
if this was the mind frame today. Imagine if after an ever bullish provocateur
sighted historically low interest rates as part of their argument if the
financial journalist queried them with Sir/Madam, are you saying you are more
of a buyer when the cost of capital has gone from 3.5% to 5% than you are when
the cost of capital has gone from 15% to 9%? Imagine.
But always know which
way the winds of the cost of capital blow.
Red Fisch, LLC
Ryan Fischer manages assets and capital for his family and a
few private clients out of
commercial real estate, short paper commercial real estate, long gold and short
IWM. He can be reached at email@example.com.