Investing in the Age of QE: The Interest Rate Play That's Sabotaging Your Portfolio
[Ed. Note:Chris Mayer has stirred up a lively discussion with his recent posts on Modern Monetary Theory. Below, you’ll find Chris addresses some of the questions and comments we received from readers.]
Daily Reckoning Reader Question: Even though the banking system is setup so that QE doesn’t cause inflation, it does affect the risk free rate. How does QE, if at all, affect how you value a company? Does it make it hard to pick out a company at a good value?
Chris: I think that because QE manipulates interest rates, it makes it more difficult as an investor to figure out what’s a good value and what isn’t — because interest rates are kind of the beginning number, right? If the 10-year Treasury was six percent, then you wouldn’t be interested in a stock that’s going to pay three percent over ten years. Why bother with taking that risk, when you could just buy the Treasury? And so, that’s sort of the minimum bar of how it affects valuations of assets. And with a Treasury at two percent, naturally that tends to create higher asset prices.
That’s the risk with QE…that you’ve just created an asset bubble, and you’ve not achieved any of the other things that QE would like to achieve, like affecting unemployment or something like that. So it does make investing more difficult. It makes it more confusing.
I think understanding Modern Monetary Theory — the banking system and the way it works, and understanding the fact that interest rates are primarily driven by what the central bank chooses to do, would have meant that you would be less afraid that interest rates would be going up.
One of the most common trades over the last, five or six years, has been saying that interest rates are going to go up. And every year they continue to go down. If you had understood how the mechanics of this worked, it makes more sense. The central bank is driving down interest rates, and they’re going to be successful at that. So I would have been less afraid to invest in real estate investment trusts, things that pay a high yield that people were worried about investing in because if interest rates go up, the assumption is they’re going go down.
And I would say secondarily, is that unrelated to necessarily what MMT says, if you just look at the record, it’s more difficult to say that higher interest rates means stock prices go down.
In fact, in many cases, higher interest rates also mean high equity prices because interest rates go up when the economy is growing and things are going well, and so equity prices also go up. It’s not a sure thing to say that: oh, if interest rates go up, stocks have to go down. If you look at the history, it’s a mixed record. It really depends.
Daily Reckoning Reader Question:
When you’re looking for a company that’s well priced, do you have to be extra conservative now because of QE? Do you need to account for more volatility in stock prices, or a higher stock price because of QE?
Chris: I would say QE doesn’t necessarily effect so much how I look at individual stocks. I’m always looking for a very big margin of safety. I’d like to buy things that are cheap, but cheap alone is not good enough. I also want to have an ownership group that invested alongside us that the enlightenment of their interest is with ours. I want a business that’s simple. And I want a business that has a good balance sheet, so they can weather the storms. So there are a lot of things that go into what makes a good investment. But I wouldn’t say that QE per say has changed that approach at all.
It’s always the same, something has to make sense on its own, and ideally I want it to be able to prosper in a variety of different environments. So I always think about: well, if rates went up, what happens? If the economy slowed, what would happen? If the dollar got weaker or stronger, what would happen? And I want to find something that can survive all those different scenarios and still make us money.