Of all the quotes that caught my attention at last week's Wesco Financial (AMEX: WSC) gathering with Charlie Munger, this one surprised me the most: "Low interest rates have driven stocks up. People look at the yield on two-year treasuries with great despair."
A few days before, the same thought was echoed by both Warren Buffett and Munger at the Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) annual shareholder meeting (as quoted by the Wall Street Journal):
Buffett and Munger said that they believe the stock market rise is a result of individual investors who are reacting with dismay to low interest rates. Retail investors are moving away from money market funds that pay next to nothing and getting into stocks.
What's surprising about this? How easy it is to refute.
Happy to earn next to nothing, thank you very much
Theoretically, the idea makes perfect sense. Since stocks and bonds compete for investors' attention, low interest rates can make bonds less attractive than riskier investments like stocks. So, if a bond yields 2% while a stock yields a 3% dividend and can grow earnings by 5%-10% a year, then stocks start looking seriously superior, and rational investors will, the textbooks tell us, reallocate bond investments into stocks.
Problem is, we aren't rational investors. On whole, we're mildly nuts. Data from the Investment Company Institute shows that by an order of magnitude, investors are still drowning themselves in bonds and steering clear of stocks.
Since the explosive stock rally began last March, investors put only a net $49 billion into stock mutual funds versus nearly half a trillion dollars into bond mutual funds. During the last four months of 2009, investors actually pulled $23 billion out of stock funds while dumping $155 billion into bond funds. Going back to January 2008, there isn't a single month where stock inflows outpaced bond inflows. It isn't even close. Even from February to April of this year -- a particularly thriving period for stocks -- bond inflows were nearly quadruple stock inflows. If investors are looking at bond yields with great despair, their actions sure don't show it.
These numbers are pretty straightforward: Investors are still cautious about stocks but can't get enough of bonds -- just the opposite of Buffett and Munger's theory.
So what's going on?
If investor participation hasn't fueled the rally, what has? Well, low interest rates can also juice stocks by making it easier to justify higher valuations. Basically, it's worth paying what seems like a premium for stocks because the returns can still be better than low-yielding bonds.
But what's really interesting is that some valuation metrics make it hard to tell whether much of a "premium" has been priced in during this rally. For example, look at this chart of consensus forward-looking earnings estimates on the S&P 500:
Source: Capital IQ, a division of Standard & Poor's.
This shows that as stocks have surged, and so have earnings estimates. By this metric (and there are many), valuations over the past year haven't risen significantly, if at all. In fact, earnings estimates have grown faster than stocks for most of the past year. That, in my view, has been the main driver behind the market's upward explosion. It's not about an influx of investors who are disenchanted with the low returns of bonds. It's about earnings.
You don't need to look hard to find specific examples of this. One year ago, Ford (NYSE: F) was nearly dead. Now it's expected to earn $1.59 per share next year. Last winter, the chatter around Bank of America (NYSE: BAC) was about nationalization. Now it's about record revenue. In April 2009, the economy lost 539,000 jobs. In April 2010, it gained 290,000. You can't judge the market's run-up without acknowledging these catalysts, all of which have exactly nothing to do with the theory that low interest rates are driving investors out of bonds.
Now, Buffett and Munger may be right that low interest rates have contributed to stocks' surge by padding earnings, particularly in the financial sector. Actually, that's undeniable. But what low interest rates have not done, as the numbers show, is lured investors back into stocks in any meaningful way.
What do you think? What do you think has been behind the market's explosion of the past year? Fire away in the comments section below.
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