‘80s Flashback Looms: High Rates, Plunging Stocks

Thursday, 31 Mar 2011 09:28 AM

By Jacob Wolinsky

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I had a recent conversation with an intelligent friend of mine who manages several million dollars. He has a very good track record, and he brought up some concerns he had about the stock market.

My investing philosophy isn’t to worry about macroeconomics, and just buy stocks when they are cheap. This methodology was inspired by legendary investor Benjamin Graham, who mentored Warren Buffett and many other great, albeit less well-known, investors.

However, I do look at the broad stock-market valuation. And the current macroeconomic picture is unprecedented.

First, for stocks: the current Shiller P/E ratio is 24. (The Shiller P/E ratio is calculated as follows: divide the S&P 500 by the average inflation-adjusted earnings from the previous 10 years.) The median Shiller P/E is 16.40, which would equal a 30 percent drop in the stock market from the current level.

However, let us look at the macro picture, which makes this more frightening.

Here are just a few items on my watch list:

- federal debt out of control;

- countless people out of work;

- a good chance of hyperinflation;

- United States involved in three wars;

- bubbles in China, Australia and Canada (Canada is a huge trading partner);

- underfunded pensions;

- high oil prices;

- chaos throughout the Mideast;

- a toxic political atmosphere in Washington, D.C.;

- state fiscal problems;

- baby boomers retiring.

Let’s focus on pensions, bubbles, oil prices, and the deficit, which all are related.

It seems that the only way out of debt problems is to inflate ourselves out of it. Ron Baron, who has an excellent long-term track record and manages close to $18 billion, stated that he likes Ben Bernanke, and thinks he is smart for inflating our way out of the deficit.

Now if we are to get to inflation similar to the early 1980s, which is very plausible due to the bubbles forming, and the fact that Bernanke wants inflation, interest rates will rise. In the early 1980s interest rates got as high as 17 percent.

When interest rates rise, people are more likely to buy bonds or CDs instead of stocks. Why buy a stock with a 2 percent dividend, when the bank will pay you 17 percent guaranteed?

For simplicity’s sake, let us assume interest rates reach 12 percent — stocks might then only have a P/E ratio of lower than 8, which is equal to an earnings yield of 12 percent.

This is what happened in the early 1980s, when the Shiller P/E reached as low as 6.64. This means the market could decline by close to 66 percent, assuming a P/E ratio of 8.

This does not mean this will happen. Interest rates might not reach 12 percent, and even if they do, stocks might not decline that much.

However, investors should be cognizant of this fact and be prepared for this very real possibility.

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