Ultra-low interest rates are a reason to run screaming from the stock market, not a reason to buy more shares, according to
Fortune's Shawn Tully.
If he is correct, the Federal Reserve's unprecedented (some would say gigantic) monetary stimulus efforts since 2008 are merely setting a trap for unwary investors.
According to Tully's conclusion, low rates "mainly breed overblown valuations, not bargains. As incredible as it may seem, they point to a dim future for today's investors."
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Tully debunks two commonly held assumptions about why low interest rates are good for stock prices.
The first assumption is that when the yield on a broad measure of stocks (like the S&P 500) exceeds the yield on bonds, it's smart to pile into stocks. By that measure, stocks are currently beating bonds by a country mile.
The second assumption is that declines in discount rates automatically raise the value of every dollar of future stock earnings; therefore, when interest rates are low price-earnings ratios are high.
"The problem with both of these justifications is that low rates typically forecast low inflation," Tully wrote.
He noted that economist Cliff Asness, co-founder of asset manager AQR Capital, did a study finding that between 1965 and 2001, the decade that preceded very low interest rates was very good for stocks, but that in the decade that followed very low interest rates, stocks did poorly.
"If shareholders held stocks for a 10-year period that ended with rates in the lowest quintile, they earned over that time more than 10 percent annually after inflation," Tully noted.
Surprisingly, the reverse was true when investors began investing during a period of very low rates.
"Those who bought shares at the end of the months when rates were lowest suffered negative yearly real returns of 2 percent over the decade that followed. So contrary to the accepted wisdom, the best time to buy stocks is when rates are extremely high, and the worst time is when they're extremely low."
MarketWatch columnist John Nyardi noted that Fed Chairman Janet Yellen and her fellow central bank colleagues are continuing to keep interest rates low while looking ahead to an economic growth rebound.
"However, if they are wrong, stagflation could be the next bogeyman on our investing horizon," he predicted. Stagflation is the harmful simultaneous appearance of high inflation, high unemployment and slow economic growth, something the United States last experienced in the 1970s.
"Keep in mind that the Fed has been attempting to stimulate the economy with low interest rates, but in a period of rising inflation, interest rates will climb, and the Fed will be forced to turn away from its easy-money policies," Nyardi explained.
"The consequence of raising interest rates and tightening the money supply is economic contraction, making the stagflation environment even worse."
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