The Risk to Equities from Rising Rates

If risk-free returns on CDs have been returning performance equivalent to risk-laden returns on S&P500, the question some investors are asking themselves is "Why take the risk?"

That’s the issue Justin Lahart explores (inadvertantly) when exploring the issue of how low rates actually are:

"Even though the Federal Reserve has been raising rates since June 2004,
they’re low historically. Over the past 50 years, the fed-funds rate
(the main overnight rate the Fed controls) has averaged 5.75%. Today’s
[4.5%] hardly seems onerous . . .


Ed Hyman, chief economist at research firm ISI Group, points out that those low, long-term yields are also a signal that returns on other investments are expected to be low.

Consider stocks. Last year, the S&P 500 index had a total return (including dividends) of 4.9%. Meantime, the average rate on a six-month certificate of deposit was 4.6% in December. They’re so close, you can imagine investors socking a bit more money in (safer) CDs and a bit less in (riskier) stocks.

These low expected returns have ramifications on economic prospects. It gives companies less reason to spend money on the equipment or new hires to expand. It gives venture capitalists less reason to fund budding businesses. In short, it discourages investment, and makes economic growth harder to come by as a result.

Today’s low short-term rates may be plenty high."

Interesting stuff . . .

Interest-Rate Lowdown
January 11, 2006; Page C1

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What's been said:

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  1. Michael commented on Feb 8

    Why take the risk?

    Because longer term, the S&P returns >10% with dividends doesn’t it?

    If you look at it too short-term, as in this case I believe, sure it fits the case. But it’s like saying the Dow was down 50 points today, why invest in the Dow when I made $1.50 in interest today in my savings account.

  2. Steve commented on Feb 8

    “Last year, the S&P 500 index had a total return (including dividends) of 4.9%. Meantime, the average rate on a six-month certificate of deposit was 4.6% in December.

    Yes the rates may now be converging, but I concur with the above comment. The average rate for the year on CD’s was much lower than 4.6. You can’t compare the average rate for stocks with the December rate for CDs.

  3. Joel commented on Feb 9

    The question is not about long term returns, the question is, What does one do now? at a time when returns have converged.

    Questions every stock ‘investor’ should ask:

    1. Why are all those people putting all that money into fixed rate instruments?

    2. Where and how did they get the money?

    3. Do I actually know anything about the stock(s) I’m buying?

    4. How long is long term? Am I prepared to wait 20 years to earn a 7% overall return? (or will I be dead or not give a damn about money then).

    5. What will I do if a significant portion of my ‘investment’ goes South?

    ”Why wish when you can have,” said Les Harlow, an old ham radio friend and a retired IBM ‘Inventor’ (so it said on his business card).

    6. What can I have today, in place of my ‘investment,’ that could make me happy (happier).

    Most of the investors I know don’t know how to calculate a rate of return. They still consider themselves ‘investors.’

  4. Abobtrader commented on Feb 10

    I agree with the first to comments. Michael nailed it. You can only argue that the two rates of return has converged if you have a very short term investment horizon.

    Even if you believe rates of return have converged temporarily, equity markets need to reward investors with a premium for the risk they take, and thus you can make the case that either fixed income yields should be bid down, or that equities will need to move higher.

    It’s also worth pointing out that almost all equity markets around the world (ex the S&P) had a stellar 2005.

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