February 2006
After an eighteen year run, the venerable Federal Reserve head has stepped down. Long-term interest rates dropped under his tutelage while inflation was controlled and the stock market produced annualized returns of roughly 12%. These achievements were not without tumultuous moments and the country (and world) should thank him for his steady hand. In this newsletter we will celebrate Mr. Greenspan’s record and lay the groundwork for our current investment strategy.
First, some historical perspective. Alan C. Greenspan was named Federal Reserve Chairman in June of 1987. He must have felt his timing was good since long-term interest rates, one of his important benchmarks, had steadily fallen from about 14% a few years earlier to just 8.4% at the time of his appointment. In addition, stocks had appreciated by approximately 18% in each of the three years before his new assignment. As older readers may chillingly recall, interest rates reversed their downward trend just after Mr. Greenspan was appointed and soon contributed to a market crash when stocks retreated by 22% in October, 1987.
The chart below shows some important developments witnessed over the full view of Mr. Greenspan’s tenure. Specifically, long-term interest rates moved down, while the S&P 500 moved much higher, though not without a painful bear market in 2000-2002. Inflation remained well-controlled and this fact helped to move interest rates lower.
Let’s expand our analysis to include the last twenty years when the combined impacts of falling interest rates, steady corporate earnings growth and improvements in productivity influenced stock investment returns. From 1985 to 2005, corporate earnings of the S&P 500 companies grew approximately 8.2% per year, while the underlying total returns to shareholders was an even greater 10.4%2. The difference, and added gain for investors, came from an expansion of the overall market’s price-earnings (P/E) ratio. Simply put, due to the market’s confidence in Fed policy and the downward trend in interest rates, combined with improved productivity and favorable tax policy, the overall P/E multiple with which investors value the stock market has risen.
What do we think is in store for the new Chairman, Mr. Bernanke? Unfortunately, we do not see today’s fairly low interest rates dropping much in the coming years; if anything, they may trend higher. The ongoing inflation question is difficult to predict. All told, since we project continued productivity gains due to advances in technology and global sourcing of labor, we expect a relatively calm 2% – 3% inflation rate going forward. The scarcity of some natural resources may drive certain prices higher. There is also the likelihood that the United States continues to borrow to fund trade and budget deficits and must pay higher interest rates to attract investors. While we do not have calamitous projections in regard to interest rates, we simply cannot imagine that they will go much lower from here.
So what does this mean as we position our clients’ portfolios? First, now that interest rates have bounced off their unusually low “post 9-11” levels, our bond portfolios are earning higher current income. Among our stock portfolios, those same higher interest rates are a mild headwind for stocks; in a similar vein, gains from higher P/E ratios alone are, probably, mostly in the past. The challenge for us, then, is to target equity investments in those companies and sectors that offer “value-to-growth” prospects exceeding that of the overall market.
Accordingly, we have aligned our Global Core equity portfolio to include higher growth stocks in the medical products, natural resources and technology industries, among others, and have increasingly favored somewhat smaller, “Mid Cap” companies in the $1.0 – $20.0 billion range where we feel the value-to-growth relationship is reasonable. For fully diversified equity portfolios, we have also repositioned our global investments in favor of additional developed market and emerging market offerings, which we believe offer excellent diversification and may have opportunity for higher growth.
In conclusion, investors should be mindful that the broad equity market may deliver more modest returns going forward than in the Greenspan era, and that efforts to improve diversification toward global and growth investments may be advisable. As for Mr. Greenspan, we are thankful for his service and as the title of our newsletter indicates, “Let’s Raise One to Mr. Greenspan!” His fiscal response to our toast was typical of late…as he too “raised one,” an interest rate that is, on his last day at the office. Thanks!
Your comments and questions are always welcomed.