by Rob Bennett
Five-year certificates of deposit (CDs) were paying returns of 7 percent in the late 1990s. Other super-safe asset classes were also offering generous rates of return. At the top of the bubble, Treasury Inflation-Protected Securities (TIPS) and IBonds were paying returns of 4 percent real. It was even possible to lock in that juicy risk-free return for 30 years.
It’s not like that today.
Buy-and-Holders believe that the reason why the returns being paid on safe asset classes are lower today is that interest rates are lower today. Looking at things from a purely rational perspective (as the Buy-and-Holders always do), that makes perfect sense. The economy is not doing as well today. So money cannot generate as much in the way of profits. So it is not worth as much. So investors don’t get paid as much to turn over the use of the their money to others.
There’s no question but that there is a connection between interest rates and CD returns. The Buy-and-Holders are not entirely wrong. But I believe that they are missing an important piece of the puzzle -- the role played by investor emotion in setting not only stock prices but CD (and other safe asset class) returns.
The thing that throws the Buy-and-Holders is that their understanding of causation is wrong. Interest rates are low today because the economy is depressed. Fair enough. But the Buy-and-Holders presume that it is the crashing of the economy that caused stock prices to crash. I think it’s the other way around. A price crash became inevitable once prices rose to insanely high levels. The price crash subtracted huge amounts of spending power from the economy. The reduction in spending power collapsed the economy.
It’s important to know what caused what. Our understanding of that point affects our understanding of why CD rates are low today.
Say that I am right that high stock prices caused the economic crisis and today’s low interest rates. If that’s so, the Buy-and-Holder’s presumption that today’s interest rates are rational is misplaced. Those interest rates are the product of investor irrationality.
That was so in January 2000, when CD rates were high, and it is so in 2011, when CD rates are low. Do away with the presumption of rationally and you open up the possibility that today’s CD rates may be more attractive than they appear to be.
The primary reason why TIPS and IBonds and CDS were paying such absurdly juicy returns in January 2000 is that stock prices were sky high. When stocks are priced at three times fair value, irrational exuberance is at its zenith. That means that 90 percent of investors want to buy stocks, stocks, stocks, stocks, and price considerations be darned! There would have been no market at that time for CDs paying reasonable, rational rates of return. To sell their CDs, banks had to jack up the returns offered on them to sky-high, once-in-a-lifetime levels.
There are lots of people looking for an alternative to stocks today. So banks trying to sell CDs do not need to offer high rates of return to entice buyers. Thus, investors who are frustrated with years of poor stock returns but not yet willing to let in the painful reality that they were fooled by the Buy-and-Hold marketing slogans are electing to stick with their high stock allocations on the thinking that the rates of return available elsewhere are just not appealing enough to justify moving out of stocks.
The point that they are missing is that stock prices always end up at one-half fair value in the wake of an insane bull market and they do not make their way from three times fair value to one-half fair value in a short period of time. It takes years for investors to come to terms emotionally with what they need to come to terms with to permit stocks to lose five-sixths of their value.
If you went with CDs or TIPS or IBonds in 2000, you obtained a return five percentage points higher than the stock investor for 10 years running. That’s not bad at all. But the investor who possesses the smarts to go with a low stock allocation today stands to earn an even bigger return differential over the next few years.
For stocks to fall to one-half fair value over the next few years, we would need to see a 65 percent price drop from where we stand today. Stock investors are likely to see far worse returns over the next three or four years than they have seen over the past 11 years.
The other side of the story is that those buying CDs today are likely to see a far higher return on their money than did those who bought CDs in the late 1990s. The nominal return is far less. But we are today 11 years closer to being able to purchase stocks at reasonable prices than we were in January 2000. Put your money in CDs until the next crash and you will be able to invest in stocks at prices at which the likely annualized 10-year return is 15 percent real.