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The Federal Reserve Chairman announced a .25% Fed Funds rate hike today. During the talk, Jerome Powell said the Open Market Committee is consider raising the Fed Funds rate two more times next year given the analysis of information they have available and that this could change depending on future economic events. While he gave his talk, the equity markets made a 500 point turn for the worse and interest rates on bonds longer than 2 - years dropped flattening the yield curve even more. The 1 - year Treasury yield ended the day at 2.62% with the 30 - year yielding 3.0%.
Here is what I know. The Fed Funds rate is sitting at 2.25% with the Fed Chairman planning to raise it another ¼ point twice next year bringing short term rates potentially as high as 2.75%. The 10 - year Treasury yield is now 2.77%. The Standard and Poor’s 500 Index’s future 12 - month price/earnings estimate is 14.3. Given this, I calculate the 12 month estimated earnings yield of just about 7%. This tells me either prices, earnings or interest rates need to change.
Given long term interest rates went down on today’s rate hike news, I doubt that long term interest rates will go anywhere close to 7% in this environment and this will more than likely keep the Fed Funds rate no higher than 10 year rates (2.77% currently).
I think a more likely scenario would be that either stock prices rise bringing the P/E up and thus a lower earnings yield, or earnings drop. A drop in earnings would likely be caused by a recession defined as a decrease in GDP. Recessions tend to be accompanied by excesses in capacity that I do not believe we are seeing currently. I have not heard a reasonable case we are going into a recession. With that said, one never knows, but I think it is more likely that GDP slows than drops. Given the majority of analysts followed for their accuracy of predicting earnings trends, I think it is more likely we will see the majority of those earnings estimates met and stock prices rise on the news.
I cannot remember a time of so much uncertainty. We have an ongoing dispute with our trading partners, the unknown potential Brexit could have on trade, two more possible rate hikes and an ongoing investigation of Russian involvement with the election. All of this coming with a change of majority in the House of Representatives and a growing media that reports news that they think their partisan audience wants to hear or read. I’m not sure we could have more uncertainty.Behind all bad news is the potential for opportunity. I like to follow a more rational optimist view. With so much negative sentiment, all news tends to be good news (or at least better than the worst case scenario.) Returns in stocks can be substantial before the end of an expansion. With valuations as they are both domestically and even more so internationally, interest rates seemingly as low as they can get, and the large discrepancy between interest rates and potential earnings yield, I believe stocks will outperform bonds and cash for long term investors. Good or better news can be a catalyst to even higher prices.
The last couple of months have been difficult for investors on a valuation sense as well as the unlimited amount of news, emails, tweets and the like on the subject. During this time, it is very important to keep an eye on valuations as well as making sure your investments meet your goals and objectives. If you are concerned, please let me know and we will do a review. Most importantly, please enjoy your Christmas and/or Holiday Season. I look forward to working with you in the New Year.