Whether you're a first-time investor or a seasoned veteran, chances are good that if you've been investing over the past five years you've seen your portfolio appreciate in value.
There are a laundry list of reasons that could be attributed to this long-standing rally on Wall Street, including an improving economy, lower unemployment, historically low lending rates, rising home prices, better capitalized banks, and yes, even the herd mentality.
However, there's also one glaring fact that strikes me as concerning about this rally: The majority of investors are really uninformed and unprepared for the long haul.
Published in 2012, the Investor Education Foundation of the Financial Industry Regulation Authority, or FINRA, conducted a public education survey to discover what investors felt they understood and what they actually understood. The questions covered a number of fairly basic investing topics, including the risks associated with stock versus mutual fund investing, as well as the correlation between bond prices and interest rates.
72% of investors got this wrong
The following question truly stumped a majority of investors (see if you can figure out the answer before reading on):
"If interest rates rise, what will typically happen to bond prices?"
- They will rise.
- They will fall.
- They will stay the same.
- There is no relationship.
- I don't know.
Got your answer?
The correct answer is that bond prices will fall since bond prices and yields have an inverted relationship. However, according to FINRA's study just 28% of respondents got this question correct, with 37% answering that they didn't know. In other words, 72% of investors have no understanding of the basic principles of bond prices and bond yields, yet two-thirds of respondents before the survey felt they had a high level of investing knowledge.
That's a big problem.
Occasionally ignorance can be bliss in the investing world, but when the Federal Reserve has been purposefully pushing to keep lending rates near historic lows for years to allow the economy to recover, and investors fail to understand the mechanics behind what the Fed is doing, we could be setting ourselves up for disaster.
A majority won't understand QE3
The Federal Reserve's plan, known as QE3, has been to pump money into the economy on a monthly basis through the purchase of mortgage-backed securities and long-term U.S. Treasuries. Because long-term Treasuries help determine 30-year mortgage rates, by purchasing bonds the government was pushing bond prices up and yields down. The goal of QE3 was to help the U.S. economy find its footing by allowing homebuyers to refinance or buy at advantageous rates and allowing businesses to take on debt and expand (thus hiring new workers) because of low lending rates.
At one time, QE3 had been purchasing a combined $85 billion of MBSes and long-term Treasuries on a monthly basis, but three $10 billion cuts later we're down to just $55 billion in stimulus added each month. What this means is less money being used to purchase long-term bonds, which could lead to falling bond prices and higher yields (i.e., higher interest rates).
The problem is that 72% of investors don't understand this, which means they really don't understand what QE3 was trying to accomplish. It also means that as QE3 is wound down investors could be in for a rude awakening.
The QE3 ignorance fallout
One thing investors should be acutely aware of after a three-decade rally in bond prices is that there's considerably more upside potential in lending rates than downside at this point in time. However, with investors not understanding the correction between bond prices and rates the end of QE3 could deliver a crushing blow to the housing sector, mortgage servicing sector, and mortgage REITs, while simultaneously pumping up profits for banks and insurers.
Take the housing sector and a company like KB Home (NYSE: KBH ) , which builds homes for middle- and upper-middle-income individuals. Although money may often be less of an issue for upper-income earners, interest rates are especially crucial to the homes they buy since their mortgage loan amount is often considerably larger than that of the average American. If rates rise, which seems like a distinct possibility with fewer government Treasury purchases, homebuilders like KB Home will struggle to move inventory even if they cut production dramatically.
Mortgage services may be in for a similar struggle. Nationstar Mortgage (NYSE: NSM ) , which provides consumer mortgage servicing related to loan originations (refinancing and new mortgages), may see loan originations deteriorate rapidly. In fact, loan originations, based on the weekly Mortgage Index from the Mortgage Brokers Association, hit a nearly two-decade low in December as rates rose a little more than 100 basis points off the historic lows they hit in May 2013. If rates do tick higher as expected, mortgage servicers may struggle to find new business.
The mortgage-REIT sector has also taken its shares of bumps and bruises as QE3 has begun to be wound down, and they could take further lumps. Agency-only mREITs such as Annaly Capital Management (NYSE: NLY ) and American Capital Agency (NASDAQ: AGNC ) are going to be squeezed from both ends, with higher interest rates tightening their net interest margin spread and fewer loan originations reducing the number of high-quality MBSes on the marketplace to be purchased, only beefing up competition and hurting margins between these companies.
Higher lending rates as a result of QE3 could hamper business hiring as well. A number of businesses have used low lending rates as an excuse to take on debt and expand. Without historically low lending rates available businesses may choose to put off hiring until such time as their cash flow, rather than debt, allows them to expand.
It won't be bad news for everyone, though, as fixed-income portfolio managers and banks will benefit from higher lending rates. Deutsche Bank (NYSE: DB ) , which took the crown in 2012 for owning the largest share of the fixed-income trading market within the U.S., will benefit from higher interest rates, while insurance companies which typically invest in safe vehicles such as bonds and CDs should see higher investment income as yields rise.
If investors understood these correlations, they could prepare for the possible fallout or windfall profits in a number of sectors -- but a majority simply don't understand this basic concept. Needless to say, I'm growing more convinced that the markets' uptrend is on borrowed time.
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