By: Dividend Sensei
Since the financial crisis nearly destroyed the global financial system and plunged us into a depression the US Federal Reserve has moved heaven and earth to provide liquidity, ie “New Money” to the US economy.
QE1: Nov 2008 through March 2010: Fed buys $1.35 trillion of US Treasuries and Mortgage Loans
QE2: Nov 2010 through June 2011: Fed buys $600 billion of long-term US Treasuries
Operation Twist: Fed sells $400 billion worth of US 3 month to 3 year US Treasuries and buys $400 billion of 5-30 year US Treasuries
QE3: September 2012 through October 2014: Fed buys $1 trillion in Mortgage loans.
That’s a total of $2.95 trillion of freshly printed money the Fed injected into the US financial system, which combined with interest rates spending almost 7 years at 0% to 0.25% helped to create the lowest borrowing costs in the history of Corporate America.
Now the Fed is wanting to normalize rates, meaning raise them higher to provide some dry powder for when the next US downturn hits so the Fed can hopefully avoid following the lead of European, and Japanese Central Banks into their dangerous experiment in negative interest rates. The first hike came on Dec 16, 2015, and was quickly followed by the markets first 10% correction in over three years.
Since that time weakening US economic growth, continued global weakness, low oil prices (keeping inflation pressure low), concerns over China’s mountain of unstable, and poor quality debt, and of course Brexit, have lead to no more rate hikes, despite the Fed’s initial projection that we would see 4 increases in 2016.
Which brings us to today. There are 2 more Fed meetings this year, Nov 2, and Dec 14. The financial market’s currently place the probability of rate hikes at these meetings at:
Nov 2: 9.3%
Dec 14: 65.6%
As for 2017, well the Fed’s voting members think that rates will climb to 1.25%, meaning 3 increases over the next 14 months. The financial markets disagree with the current probability of interest rates by September 2017 at:
1 Rate hike by then: 82.9%
2 rate hikes: 40.2%
3 rate hikes: 11.1%
4 rate hikes: 1.6%
5 rate hikes: 0.2%
The Fed’s long-term projection is for rates to rise to 3.25% by the end of 2020.
So you might be wondering why does this even matter? Why is the market seemingly so obsessed with what the Fed will do next, that today’s stock prices are seemingly dependent on the latest news from what a Fed member said?
The answer is because cheap plentiful money has allowed stock prices to rise to outlandishly overvalued levels, disconnected from underlying fundamentals. For example, corporate earnings have declined 5 quarters in a row, and are expected to decline again, on a year-over-year basis, this quarter.
Yet despite this earnings recession the market is still near it’s all time high.
This is partially for two reasons. First, with US Treasuries at near record lows, and foreign bonds offering negative interest rates for durations as long as 50 years, there is simply no place that income investors can turn to other than blue chip dividend stocks such as Johnson & Johnson, Coca-Cola, and Procter & Gamble.
Similarly, REITs, and Utilities are seen as similar higher-yielding alternatives, with the highest quality names, such as Welltower, Realty Income, and Ventas, offering safe, and secure income.
In addition, low borrowing costs have resulted in a record amount of corporate borrowing, which has fueled the largest pace of buybacks in history. In a low volume environment, in which retail investors remain skeptical of the rally, corporations have been successful in pushing up the prices of their own shares to record highs.
In other words, thanks to plentiful, nearly free money for the last 7 years, we’ve seen the inflation of a large stock bubble, (as well as bubbles in bonds, and real estate).
If the Fed makes good on its plan to raise rates by as much as 2.75% over the next 4 years, then US treasuries will rise as high as 5.25% for 30 year bonds. That will finally offer savers, as well as Pension funds, endowments, and various charitable foundations a high, safe form of return. Which in turn will mean the demand for REITs, Utilities, Consumer Staples, and other defensive dividend stocks will fall, so that their yields rise to represent a small to medium sized risk premium.
After all, all companies, even AAA Microsoft, and JNJ are in reality more risky than US bonds, which are guaranteed by the full faith and credit of the US government’s printing presses.
Similarly, a 2.75% increase in borrowing costs would mean far less buybacks, further depriving the market of further fuel to continue it’s 8 year bull run.
Bottom line is: higher interest rates mean the Fed’s free money Fiesta is over and stocks are likely to fall to levels supported by their fundamentals.
So how should you set up your portfolio to take advantage of rising rates? The simple answer is you shouldn’t change a thing.
Other than a few industries that benefit from rising rates, (due to fatter lending spreads) such as banks, insurers, and payroll processors PAYX and ADP, there isn’t any need to change your allocation.
That’s because, the kinds of quality, dividend growth stocks you should own, even if they are in interest rate sensitive industries such as REITs, need to be adaptable, and able to cope with different economic, and interest rate climates.
And indeed the best REITs have proven great long-term wealth generators. Examples such as Realty Income, Welltower, Ventas, and Iron Mountain have been around for decades, sometimes even half a century, and been through numerous business and interest rate cycles.
The same with regular dividend stocks, like 3M, IBM, or Disney. Interest rates spiked to 22% in April of 1982. Yet these firms managed to continue growing their businesses, cash flows, and most importantly of all, their dividends throughout this time.
Oil shocks, war, recessions, rising rates, falling rates, they carried on through it all. All the while the market rose 70% of all years, always climbing a wall of worry over something or another.
So while Fed Watching may be the new national pastime, always remember that rate hikes only affect stocks in the short-term. Which means that what Janet Yellen was wearing today doesn’t in fact mean you need to run out and buy this or that. Just focus on the tried and true methods, of buying high-quality dividend growth stocks, hold for the long-term, add on dips, and reinvest the dividends.
Do that, and you’ll find that 99% of the time the key to becoming rich is just sitting on your hands and doing nothing.