Over the past 21 months, higher interest rates have hurt stock returns. But will that continue? Peter Mallouk and Jonathan Clements tackle this question on this month’s episode.Plus, Peter encourages listeners to “celebrate along the way” — and discusses the sad news prompting his advice.
Hosted by Creative Planning Director of Financial Education, Jonathan Clements, and President, Peter Mallouk, this podcast takes a closer look into topics that affect investors. Included are in-depth discussions on financial planning issues, the economy and the markets. Plus, you won’t want to miss each of their monthly tips!
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Jonathan Clements: Hi, this is Jonathan Clements, Director of Financial Education for Creative Planning. With me is Peter Mallouk, President of the firm, and we are Down the Middle. Go back 21 months to year-end 2021. The 10-year Treasury note was yielding 1.5%. Today, it’s yielding 4.5% or three times as much. That in a nutshell is one of the major reasons that stocks, despite rallying over the past year, remain roughly 10% below their all-time high. So, Peter, what is it about higher interest rates that make investors less enthusiastic about stocks?
Peter Mallouk: I think it’s really a hard concept for a lot of people to understand, so I always try to start by explaining it outside of the stock market. So, if you’ve got investors and they’re looking at, say, an office building or a storage facility that they want to buy the real estate property and then rent it out. If interest rates are really low, if they’re 3% and you can borrow at 3%, you go “Hey, I can go buy this building. And, I’m going to collect my rent, and paying my mortgage is going to be pretty easy, because the monthly cost is pretty low.” Well, if the borrowing cost is instead 8% or 9%, well, you’ve got to make sure that place is leased out. And, you’ve got to make sure it’s leased out at high rents to be able to cover that. In other words, you need a lot more income to cover it.
Or, if you own a property and you’ve got a 10-year lease on the property and your interest rate is variable and a couple of years ago it’s 3% and today it’s 8% … Well, all that money that was going in your pocket is now making interest payments. And so, I think that’s generally easy for people to understand.
Well, when you walk over to the stock market, companies are very similar. Most companies are carrying debt, so part of their cost of doing business is they borrow money to finance operations or acquisitions or invest in research and development and so on. So, when the cost of carrying that debt goes up, it eats into the profits and all stocks’ prices are based on future expected profits, future expected earnings. So, if I know more of those earnings are going to go to make interest payments, there’s going to be less earnings. So, that’s one of the reasons that really hurt stocks.
The other reason is investors are generally logical creatures. I say generally because there’s a big behavioral element here. But, when they look at a Treasury note and it’s at 2%, they go, “You know what? That’s nothing. And after taxes, I’m getting 1.2%. I’m going to go to the stock market and put up with the volatility to get the historical 8%, 9%, 10% return.” When the Treasury’s approaching 5% and you’re going, “Look, risk-free, I can do nothing and get 5%.” — now on an after-tax basis, it might be three point something — it’s a little harder to entice me to go over to the stock market and deal with the drama of the stock market. And so, that’s another part of what impacts things is the investor’s ability to make decisions. All of those things really hang like a black cloud over the market.
Jonathan: And right now, pundits are talking about that black cloud hanging around for longer. They’re talking about interest rates staying higher for longer. Should this worry stock investors? Does it mean we’re going to end up with lower long-run stock returns?
Peter: Now, here’s what is incredible about this, and I think will surprise many listeners. And, I had to review a bunch of charts to believe it myself. Higher interest rates are not indicative at all of future stock market returns. So, if you look at interest rates at 2% or 7% and you look forward at the probability of having market returns that are positive and in line with historical norms, there is no correlation between interest rates and stock market performance. And part of the reason for that is when interest rates are really low, it’s because the economy is generally weak and the Federal Reserve is lowering rates to try to entice people to go buy cars and refrigerators and stocks and so on.
And when they’re higher, it tends to be because there is too much spending, which is driving inflation. So, you really cannot look at interest rates by themselves, or really at all as a market indicator of future performance. You really should just continue on investing. The odds you’re going to have a positive return in the next 12 months are 75%. The odds you’re going to have a positive return if we stretch it out over three years or well over 90%. And, the further out you go, the more expected it is. But making short-term decisions based on interest rate is a fool’s game.
Jonathan: So, one of the things that’s been sort of surprising, even amid these rising interest rates, is the economy has continued to plug along and companies have continued to grow. I pulled these numbers from analysts at Standard & Poor’s. They expect reported corporate earnings to be up 15.8% this year and next year they’re talking about 12.5%. I mean, even if stocks look expensive today, and even if interest rates stay high, wouldn’t growth like that make market valuations pretty attractive pretty quickly? In other words, Peter, isn’t this the case where time will heal all wounds?
Peter: It is a case where time will heal all wounds. And that’s basically the story of the stock market. Time is the investor’s friend. And for the person that’s patient, they wind up winning every single time. But, you have to somehow get through this noise, focus on the long run. If you can control your behavior, you can control your outcomes and this is going to be a classic example of that.
Jonathan: For listeners, one thing to keep in mind is that while you as an individual can look out into the distant future and take that long-term perspective, there are so many people kicking around Wall Street who have a short-term perspective. They’re worried about what their year-end bonus is going to be. They’re worried about what they’re going to say on CNBC that’s going to be catchy tomorrow. You don’t have to worry about that nonsense. You have the advantage of having this longer time horizon than the typical professional on Wall Street, and you should turn that to your advantage. And this, to my mind, is one of the advantages that everyday investors have today, given the turmoil in the market and all the drama and so on. You can look beyond this current valley to the hill ahead. And, that should work to your advantage. So Peter, the normal point of the podcast. It’s time for your tip of the month. What have you got for me this month?
Peter: So, one of the things I think I’ve ended almost every book I’ve written with, and that you and I have talked about a lot, is the importance of celebrating along the way. Because we all have goals. We have personal goals, business goals, all kinds of goals. Most people listening to this care about their financial future. They might be clients of Creative Planning or not, but they’re building plans of, “Hey, here’s where I am. Here’s what I’m trying to do so I can do these things.” “I can do this charitable giving,” or “I can take care of my kids,” or “I can live a good retirement,” or whatever. But I always talk about one of the things I learned many, many years ago is, you better enjoy the journey more than the destination, because we don’t know that we’re going to get to the destination.
And, one of the key people at Creative Planning, Jim Williams, our Chief Investment Officer, passed away suddenly this past weekend. And, it’s been so devastating — a personal loss. I mean, professionally, there’s always someone else that’s incredibly capable of being the Chief Investment Officer or fit any role. It’s like a guitarist in a band. The easiest thing to do is find somebody else who can play all the songs. The hard part is what it was like to play together, or what it was like before the show, or on the road and so on. And I think that describes Jim Williams in a nutshell. He was just such an integral part of the team.
But, what I am grateful for is that we celebrated all the time along the way. We didn’t say, “Someday when we accomplished this as a group, we will do that.” We along the way, all the time, found times to pause, thank each other, celebrate each other. And, as an entire firm, we find ways to celebrate. And so, I am very grateful that I learned that lesson from my clients decades ago and incorporated it into my life. And it gives me some solace as I think about what we’re all going through here. How about you, Jonathan?
Jonathan: Well, Peter, I think given the talk of Jim, who was a real gentleman and a great person to be around, I think going on to any hardcore financial topic at this point would be inappropriate. So, I think we’ll leave listeners with the lovely words that you just expressed. This is Jonathan Clements, Director of Financial Education with Creative Planning. I’ve been talking to Peter Mallouk, President of the firm, and we are Down the Middle.
Disclosure: This show is designed to be informational in nature and does not constitute investment advice. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy, including those discussed on this show, will be profitable or equal any historical performance levels.