How Interest Rates & Valuations are Affecting the Markets

By Dean Barber

May 30, 2018

Welcome to the Monthly Economic Update, we’re not quite at the end of the month yet it’s May 24, 2018 as I write this so the data I use today is up through May 24th. As of today, the markets are down pretty substantially with President Trump writing a letter to Kim Jong-un putting the talks with North Korea on hold indefinitely. That has the markets in a bit of turmoil, down at this time about 250 points.

I want to talk to you about what is really happening in the markets, and how interest rates and valuations are affecting the markets. I’d like to start with a chart reviewing market valuations. We’ve been over this chart before, so if you’re familiar with it please bear with me as I explain the chart and the data we’re actually looking at in the chart.

Valuations Over Time

Figure 1 – Valuations Over Time –

What we’re looking at in Figure 1 is valuations over time. This chart runs from 1900 to all the way to April 2018. You can see the solid red line, that is the mean or what is considered to be fair value to the market. Interestingly enough, markets don’t typically trade at fair value. They will either trade far below fair value as you can see when the blue line is below the mean or they trade above fair value as you can see when the blue line is above the mean. For a long period of time now, since the early 1990s, markets have in an overvalued position with the exception of the very early part of 2009 just at the end of the Great Recession.

Somethings to point out on this chart. This chart is an average of four ways to measure valuations in the market the Crestmont P/E, the Cyclical P/E, the Q Rations developed by Tobin, and the S&P 500 from its regression. If we look at the average of all four, in the box on the top left of the chart, we see that the markets are showing an overvaluation of 110% at this moment. This means that stocks as a whole, the broad market, is trading at 110% above fair value. That in and of itself is not necessarily a scary thing. What I want you to take notice of is that prior to the Great Recession markets were trading at 71% above fair value, and just prior to the Dot Com Bubble markets were trading at 155% above fair value. Even going back to 1929, just before the Great Depression, markets were trading at 87% above fair value.

There were some dynamics at play in the Great Depression and Great Recession that really exacerbated the losses that occurred in the markets and throughout the entire economy that aren’t as prevalent today or in 2000 when the Dot Com Bubble burst, and that is debt. In the 1920s a lot of the assets that were in the market were purchased on margin, or with money that people didn’t really have. They borrowed the money to go out and invest in the market because it seemed like a no-brainer. You could borrow some money, go invest it in the market, and you’re making money on somebody else’s money. In 2008, the entire Great Recession was precipitated by the Real Estate market and bad loans which leaked into the Prime Loan market. Once again, with the Great Recession we had a debt problem. Today that debt problem isn’t necessarily what it was in 2007, but there will be bear market and when valuations get to the point where they are today it puts us in a cautionary mode.

We follow three different indicators. A short-term indicator for weeks to months, an intermediate indicator for quarters, and a long-term indicator for months to years. If all of those are pointing positive that gives us a green light to say everything looks really good. Well, for the better part of this year our indicators have been mixed. In other words, some have been negative while others are positive and that’s put us in a neutral position causing us to want to be a little more conservative.

With market valuations where they are today and market indicators overall in a neutral position, it warrants some caution. Anytime we hear talk about Russia, China, North Korea, or about terrorist activities we see markets react wildly. Another big thing you’re probably hearing a lot of talk about is rising interest rates and every time we talk about those we also see the markets react wildly. The reason is market valuations today are primarily being supported by the ultra-low interest rates. As the economy as a whole does well, and it is doing well, that will cause inflation and the Fed to increase interest rates. Those increased interest rates could cause markets to come down because today the valuations are being supported by those ultra-low interest rates. Bottom line, where we stand today and why we’ve had so much volatility so far this year, it’s all about what is going on geopolitically and domestically with interest rates. It’s the geopolitical fears and the domestic interest rate/inflationary fears.

Sector Performance

Figure 2 – Chaikin Analytics –

Let’s take a look at what’s going on in the markets. I want to focus just on sectors of the market. Above, in Figure 2, we’re looking at a year-to-date chart and you can see that Technology has continued to be the clear winner in the overall markets, up 9.27% year-to-date. Energy has really taken over in the last couple of months as the clear winner. As you can see in Figure 3 below, Energy at one point this year was down about -8% or so and now is up about 7.74% which is driven by what’s gone on with oil prices. The S&P 500 is positive by 2.44%. If you look at Utilities, Real Estate, and Consumer Staples or what would be considered the “safe haven” type of investments, those are all in highly negative territory this year, and we’ve seen a lot of volatility.

Figure 3 – Chaikin Analytics –

I expect the volatility to continue here over the next month or two. We don’t know how much higher these markets can go, but we do know that as the economy continues to do well interest rates are going to continue to go up and it will continue to put pressure on the equity markets. That being said, I think the “easy money” that we saw being made in the markets last year is something that’s behind us at the moment. That doesn’t mean you can’t make money or that it’s impossible, it just means that you need to use some caution. Which is what we are doing with our portfolios here at Barber Financial Group.

Interest Rates

Figure 4 – U.S. Treasury –

It’s no secret that interest rates have risen this year. Above, in Figure 4, is a chart comparing where the 1 Month Treasury all the way up to 30 Year Treasury was a year ago to where they are today. A year ago, the 1 Month Treasury was at 0.67% and is now at 1.76%, so we’ve seen a 1.1% increase. Looking at the 10 Year Treasury a year ago it was at 2.33% and is now at 3.01%, so only about a 0.7% increase there. The 30 Year Treasury has hardly moved at 3.00% last year and now at 3.17%. Most of the activity of the increase on interest rates has all been on the left side of Figure 4, or the shorter end of the yield curve. That activity could make its way into the longer end of the yield curve like the 10 Year and the 30 Year Treasuries. In order for that to happen, I believe that’s going to require something completely different to take place in our economy, money velocity is going to have to take off. We’ll try and dive into money velocity and how that drives inflation and correlates to the 10 Year Treasury in our next month’s video.

Suffice it to say, some of the volatility has subsided, but I don’t think it’s over yet. I think we’ll continue to see some volatility. We are in a cautionary cycle and we do have equities that are overvalued, but the backdrop of the U.S. economy is still very strong. However, that doesn’t mean we can’t see corrections or even bear markets even in a strong economy especially with valuations as high as they are today, and those valuations being supported by the ultra-low interest rates.

There are a lot of factors at play and we’re more than happy to sit down and speak with you about any questions you may have regarding your portfolio construction and the strategies that we use. We’re always trying to make sure that the portfolios we manage are positioned in a way where we can grow responsibly and still be safe when it’s prudent.

Have a great month of June and I’ll be back next month.

Dean Barber

Founder & CEO

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The views expressed represent the opinion of Barber Financial Group an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Barber Financial Group does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.