News from Kerr Financial Group

While the Oracle of Omaha has had wittier quotes and scribes, it does not detract from the importance of this statement.  Further it is a simple, direct proclamation that could be lifted from a Financial Analysis 101 textbook.  Nevertheless it has three important assumptions that go to the heart of investment analysis – cash inflows, cash outflows, and the discount rate (interest rate).

Jim Grant followed the Buffett quote by focusing on the interest rate component.  He asks, “It would be nice to know where they’re going” and “It would even be nice to know what they mean”.[ii]

The direction of interest rates in the U.S. is a white hot topic and debate over their future has intensified. As for the meaning of the current state of interest rates, it is clearly distorted by central bank intervention and manipulation.

In May Fed Chairman Bernanke mentioned that the central bank may “taper” the monthly $85 billion buying of Treasury bonds and mortgage securities.  This put a scare into the fixed income markets.  Interest rates, which had been rising since the beginning of the month, accelerated their climb.  The 10-year Treasury note moved through 2% and has kept moving higher throughout June and July reaching 2.73% at the start of August.

It’s easy to dismiss a 2.7% level as unimportant or inconsequential.  And for those who can remember life before the financial crisis and quantitative easing, these interest rates are still low.  To better understand the pain in the fixed income markets during the past few months, one needs to consider a 100 basis point move relative to a 1.65% starting point.  In other words, we’ve had a 60% move higher in the 10-year’s yield.  While many were predicting higher interest rate, not many investors were prepared for such a dramatic move in a short time.

What the future holds for interest rates is a critical question.  Some believe that the Fed will begin to slow their bond buying program which will apply further upward pressure on rates.  Others forecast higher rates due to increased inflation and economic growth.

There are others predicting a reversal of this recent spike.  Their view revolves around the belief that the Fed won’t end QE and that the economy is not that strong.  July’s employment report makes a case for this view.  While there was an increase of 162,000 jobs in the month and the overall unemployment was the lowest since December 2008 (7.4%), some underlying details were weak.  A low participation rate (63.4%), a drop in weekly earnings, and a high number of workers considered long-term unemployed (4.2 million Americans) give defense to those who argue against any near term end to Fed bond buying.

For those supporting the glass is half full view, second quarter earnings have not been bad.  According to Merrill Lynch, sales and earnings expectations are higher now than they were when the quarterly earnings reports began in early July. Sales predictions for the quarter are now 1% higher than they were on July 1.  Furthermore, Merrill Lynch is now forecasting that second quarter earnings will be 2.7% higher than a year ago.[iii]

This just scratches the surface of the discussion over which direction interest rates will move.  And while both sides of the debate make strong cases, returning to Jim Grant’s first question, knowing the eventual direction of forthcoming interest rates will be important to the markets. We think investors should be flexible enough to adjust to either result.

As for the meaning of interest rates, it’s not what it used to be.  The zero interest rate policy (ZIRP) being implemented by virtually all central banks has clearly distorted the role that rates used to play.  Once upon a time, interest rates helped put a price on the cost of capital.  Further they were the reward for postponing consumption and saving money.  With the nominal level around 0% and the real level (the level after subtracting inflation) negative, they don’t have the same function.

In recent years, the most important meaning interest rates have is as one of the tools used to stimulate the economy.  In this regard, there has been an uneven reaction.  While the job market hasn’t responded as hoped, housing has been a clear beneficiary.  Looking across the rest of the economy, the impact has been lumpy.

The stock market has been another clear benefactor of ZIRP and QE.  After Chairman Bernanke’s “taper” remarks, equities weakened into late June.  From there they rebounded and made fresh record highs on August 2.  Stocks retreated a little last week as the Dow Jones Industrial Average lost 1.5%, ending a stretch of six weekly gains for the blue chips.  Here is the major averages year-to-date performance.

                                                                        2013[iv]

Dow Jones Industrial Average                           +17.76%
S&P 500                                                             +18.6%
Nasdaq Composite                                            +21.2%

Russell 2000                                                       +23.4%

Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends

If the current meaning of interest rates is unknown, the stock market is at least an equal mystery.  Are stocks that dependent on the Fed that as soon as the end of easing is just mentioned prices move lower?  Are corporate earnings sustainable without low interest rates?  To these questions add variables such as the European crisis, geopolitical issues, and fiscal deficits that are not being addressed.  We offer that neither Warren Buffett nor Jim Grant have definitive answers.

Despite these issues, it’s hardly the time to raise a white flag.  While we don’t

As we plod through the markets’ gyrations, we’ll be on the lookout to buy situations with increasing cash inflows or decreasing cash outflows or, preferably, both.  Buying these situations at the right price, as Warren Buffett would attest, is the goal.