David R. Kotok,
Cumberland Advisors, November 9, 2012
There is some post-election clarity. Markets are presently ignoring it.
“The Supreme Court of Monetary Policy” is the Federal Reserve of the United States. It has seven governors and twelve presidents. The seven governors and the president of the Federal Reserve Bank of New York vote on Monetary Policy all the time; the other eleven presidents rotate. Four of the eleven presidents vote at any one time. The decision-making authority is the Federal Open Market Committee (FOMC) with twelve voters at any one time.
Let’s count the votes. Seven governors and president Obama controlling the appointments. The Democratic majority in the Senate confirms them. In fact, Obama’s support in the Senate has grown. The threat of filibuster, or blockage by Senators, has been reduced.
The monetary policy of the US during the Obama administration is the Bernanke policy. Bernanke has clearly established a long-term policy of next-to-zero, short-term interest rates AND exceptionally and persistently low longer-term interest rates. Bernanke has delivered precisely the policy he promised. He has had the majority votes of his board and many of the presidents supporting him.
Although Bernanke is willing to tolerate dissenting votes and has had as many as three FOMC members oppose a policy move, the majority and the overwhelming, established position of the Federal Reserve is Bernanke’s policy. Bernanke’s term will end a year after the inauguration of our re-elected president, but the Bernanke policy will continue. The successor appointees to the Federal Reserve Board of Governors will be made by the president who appointed most of the present board and who fully supports the very-low-interest-rate policy.
What is clear from the election outcome is that the interest-rate policy of the US is likely to be defined for the entire Obama second term.
Markets are ignoring this idea. They do not want to accept a very-low-interest-rate policy for a protracted period of time. Markets are also ignoring the fact that the same policy is in play in nearly all major mature economies of the world. In some of those economies, the interest rates are negative. In others, they are near zero. In nearly all cases, the long-term interest rate is somewhere between one and two percent. In some cases, it is less than one percent.
When you price financial assets, hard assets, real estate, precious metals, or any type of assets, you must compare the expected return of the particular investment with the riskless return you can obtain from high-grade sovereign debt. We see high-grade sovereign debt, be it US dollar in US Treasuries, euros in German sovereign debt, yen in Japanese sovereign debt, the British pound in British sovereign debt, or the currencies of Sweden or Switzerland or Singapore. Wherever you look, the interest rates on riskless, highest-grade sovereign debt are very low. Note that in the US the high-grade tax-free money market fund in your account pays 0.01%. The high-grade taxable money market fund also pays 0.01%.
We expect this low-rate environment to translate into very aggressively rising stock prices in the next few years. We expect high-grade bond interest rates to remain low and perhaps go lower. The bond buyer index of high-grade GO tax-free bonds hit a new low yield today.
We expect real estate to commence and accelerate a recovery. That already is starting to happen in certain places. You can buy a house in the US, and your residential mortgage interest rate is somewhere around three percent. If you use an adjustable rate mortgage for seven years you are financing your house at a two-handle.
We are not now, nor have we ever been, perennial bulls or perennial bears. In our lifetime, we have been both bullish and bearish. Right now the situation is setting up to be extraordinarily bullish.
With these low interest rates expected to be in place for many years, opportunities are presenting themselves in the high-grade taxable fixed income arena. There is a yield above four percent. It is not going to stay there forever. It is going to go lower. In the high-grade, tax-free arena there is a yield of about three percent. It is not going to stay there forever. It is going to go lower. Both of those yields, taxable and tax-free, in well-selected and researched securities are higher than the treasury yields. The treasury yields are going to go lower.
Those who have been ringing their hands about the big inflation, rising interest rates, weakening dollar, fiscal cliff, tax policy, and the election rhetoric have missed markets. They now have an entry opportunity if they did not take advantage of it in the past.
We see high-grade, tax-free bonds as a bargain. We are buying those bonds for our clients. We are selecting and reviewing each and every credit very carefully. The same is true in the taxable fixed-income arena and in the stock markets selectively around the world and in the US.
For the US, we have taken up our expectations for the S&P 500 Index. We were projecting somewhere around 1,400 to 1,500 at year-end 2012. Our intermediate-term projection was 2,000 on that index at the end of this decade. We think it will be higher. We expect earnings next year from the S&P to be somewhere around $100. They may be low – $97 or $98 – or they may be high – $103 or $105. They will be somewhere around $100, plus or minus a couple of dollars. At the end of this decade we will witness a 20-trillion-dollar US economy. It will generate profits and grow at a gradually accelerating rate when you extend the GDP to the end of the decade. So, grow the economy very slowly (1.5 to 2 percent) and have a low rate of inflation. Take the S&P earnings out of the profits of that economy, and the range at the end of the decade is somewhere between $125 and $140. That makes the US stock market cheap.
Cumberland’s job is not to manage policy or politics. Our job is to manage portfolios. Cumberland’s portfolios are fully invested, and we expect they will do well over the next few years.
Let me close with one final comment that is personal.
The election rhetoric, nastiness, and meanness may continue or be over; in my view, it is likely to continue since that is part of our present-day America. Either way, the election is over. The antics of people like Jack Welch, Donald Trump, and Ann Coulter did not help their candidate. Their offensive and mean comments were not Romney’s comments, but they hurt him. The Governor Romney that I met seems like a decent man with an abiding sense of personal faith. His beliefs include community philanthropy.
This leads me to the final thought today.
The political system that we have is the one that we must live with. I do not like the system and wish it were otherwise. I do not like the meanness. I despise it. Coulter’s use of the word retard was particularly offensive and disgusting. Readers may note that the Peter Demirali memorial scholarship fund will be assisting individuals with “developmental disabilities. The beneficiaries are people who seek dignity through work. Those details will be announced shortly.
David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors
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