How Will Jitters on Interest Rates Affect Investing?
The movie that Wall Street’s bulls would most like to see right now, if only someone in Hollywood would make it: “How I Learned to Stop Worrying About Rising Interest Rates and Love the Recovery.”
With each new sign of economic recovery last week, bond investors panicked, figuring that a stronger economy will mean more demand for money and thus higher interest rates.
The bond buyers’ fears became self-fulfilling, as they demanded higher yields on bonds. By the end of the week the yield on long-term Treasury bonds was at its highest level since January--8.47% versus 8.26% a week earlier.
The stock market tried to look the other way but couldn’t for long. A quarter of a percentage point rise in bond yields may not seem like much, but each blip-up in rates makes bonds that much more competition for stocks. The Dow Jones industrial average slumped from its record high of 3,035.33 last Monday to 2,976.74 on Friday, a loss of 58.59 points, or 2%.
Assuming the economy continues to emerge from recession, most investors are stuck pondering two questions now:
* Do interest rates always begin rising the moment a recovery begins?
* And just because rates go up, do stocks automatically have to go down?
The answers, simply, are no and no.
“Historically, rates tend to rise well after the economy has begun to grow again,” says Mike Kucera, partner at Wedge Capital Management in Charlotte, N.C. It takes awhile for businesses and consumers to get interested in borrowing money again, and it also takes awhile for inflation to reheat, because businesses are cautious about raising prices when orders are just trickling back.
But there’s a problem this time around, Kucera says: Many investors have had extremely bullish expectations about how low interest rates would fall before the recovery was expected to begin. Quite a few investors expected--unrealistically--that the 30-year T-bond yield would drop to 7%, he says.
Given that the yield now is 1.5 points above that target and rising, “a lot of people are very disappointed,” he notes. Thus, the bond market is hiccuping. And that may go on for a while longer, Kucera says.
So let’s say it takes a couple of months for bonds to stabilize. If the recovery keeps progressing, stocks should be able to shake off their interest rate worries eventually, focusing instead on the expectation of better corporate profits.
In the first half of 1975, for example, stocks rocketed from their bear market lows as the economy recovered, even as interest rates also crept up.
There have been other periods when stocks divorced themselves from whatever hang-up the bond market happened to have--at least, as long as interest rates didn’t get totally out of control.
Even if rates were to stop rising at this point, many money managers admit that they’re squeamish about buying a lot of stocks here. They’d rather wait for some indication that corporate profits in fact are turning up.
Paul Fortier of Cullen, Fortier Asset Management in Woodland Hills, for example, believes that long-term interest rates have peaked. But he also says, “Stocks are not cheap now by any measure.” So his $82-million-asset firm has been trimming its stock holdings the past month or so, cutting back on such big 1991 gainers as U.S. Surgical and Medtronic.
Fortier now has a cash hoard equal to 20% of his portfolio. He figures that he’ll be able to pick up some bargains ahead, should the market stage a deeper drop over what he believes are trumped-up interest rate worries.
For investors who can focus on more than the one-day or one-week outlook, you just have to ask yourself if you believe that the economy is indeed bottoming.
If you agree with that, then there’s every reason to believe that the stock market rally will restart within a few months, when corporate profit expectations overcome interest rate moping.
“We have a situation now where things aren’t going to get worse--they’re just going to get slowly better,” says Joan Lappin, head of $140-million-asset Gramercy Capital Management in New York.
If you keep in mind that next year is a presidential election year, Lappin says, the chance that we’ll have anything but an improving economy by that point is slim. So worrying about timing the market now is a silly exercise, she figures.
Student Stock Pickers: UCLA’s Student Investment Fund held its annual meeting last week, and the six junior portfolio managers were justifiably happy with themselves.
In the year ended April 30, the students produced a return of 12.4% on the stock-and-bond fund, bringing it to $512,619--the fourth consecutive annual gain.
The typical mutual fund--one that invests with the same “balanced” approach of using both stocks and bonds--gained about 14.8% in that period, so the students lagged. But, considering that this was their first shot at professional money management, 12.4% is a pretty good number. The typical mutual fund--one that invests with the same “balanced” approach of using both stocks and bonds--gained about 14.8% in that period, so the students lagged. Especially since they had to invest through a bull, bear and new bull market all in the same 12-month period.
The UCLA fund was set up in 1987 by Bernard Johnson, head of Pasadena-based Provident Investment Counsel. The idea was to give students at the Anderson Graduate School of Management the opportunity to manage real money so they could learn from their victories and their mistakes. A small number of other universities nationwide have similar programs; UCLA’s fund is among the largest.
A new group of students runs the UCLA portfolio each year, and their decisions are overseen by a faculty committee. For the most part, the students are left to decide how much to invest in stocks, bonds and cash, and which individual securities to own.
The outgoing student managers expanded the portfolio’s stock list to 35 from 17. And along the way, the managers admit that they made a lot of the traditional mistakes that novice investors do.
In the summer of 1990, for example, when the market quickly went from new highs to outright panic over the Iraq-Kuwait crisis, “we found ourselves more reacting to news than anticipating it,” said Ashvin Syal, one of the managers.
By the fall of 1990, he said, the group learned to take a longer-term, more reasoned approach to what was happening in the market. “That was a key change,” he said.
The managers also learned that forming a consensus on individual stock choices was tougher than they figured it would be--especially since they saw over time that “some (managers) made excellent contrary indicators” with their stock suggestions, joked David Piller, one of the six.
Overall, though, some of their stock picks were dynamite choices. Piller, for example, discovered Thermo Instrument Systems, a maker of monitoring instruments for the waste-management industry. He found the company while researching through the Value Line Investment Survey. The stock was the group’s biggest gainer, up 70.8% for the year.
Piller says he was drawn to the stock by the long-term prospects of the environmental-cleanup business.
The stocks he rejected through the year were judged on the same long-term basis, he says: “I took the view that if it wasn’t a good business for the long term, it wasn’t going to be a good stock.”
The group’s losers, meanwhile, were led by software company Oracle Systems, off 55%. That was a stock that blindsided more than a few pros as well.
All six of the managers have either landed or are looking now for full-time money management jobs. They figure that the experience with the UCLA fund gives them a jump on fellow grads who have yet to manage their first actual investment dollar.
The best lesson from running other people’s money? “We learned it’s a very humbling experience,” says student manager Keith Webster.
Student Portfolio’s Hits and Misses A half-million-dollar investment fund at UCLA was managed by six grad students over the past year--their first hands-on stock-picking experience. In the 12 months ended April 30, the students’ fund gained 12.4%. Their five best and five worst stock picks: Best Picks
Stock Total return Thermo Instrument +70.8% American Water +53.8% Merck +50.0% FHP International +40.2% Philip Morris +35.7%
Worst Picks
Stock Total return Oracle Systems -55.0% Club Med -21.3% AMR (American Air) -20.3% Flight Safety -16.5% Hawthorne Financial -16.3%
Source: UCLA Student Investment Fund annual report
