Good News For Now, But Watch Rates

Things appear to be heading in the right direction as we prepare to welcome a new year. GDP growth estimates are being revised upward, corporate profits are up sharply, and stocks are about to log their second consecutive year of impressive gains. Accordingly, bullish predictions about both stocks and the economic recovery are becoming more and more commonplace. Yesterday, Jim O’Neil, Chairman of Goldman Sachs Asset Management, insinuated that 2011 will be the “Year of the USA”, with economic growth of up to 4% and stocks up 20% for the year. How did everything suddenly become so rosy?

It is true; there are many reasons for optimism right now. Monetary and fiscal policy is very supportive of economic growth and stock prices. The job market appears to be picking up a bit. Corporate balance sheets are in great shape, profit margins are very strong, and earnings (as measured by S&P 500 operating earnings) are expected to exceed all-time highs. Inflation and interest rates remain low by historical standards. Stock prices, as measured by price-to-earnings ratios, are reasonable by historical standards. Emerging markets continue to grow at fabulous rates. The savings rate has rebounded, leaving consumers in (slightly) better financial condition. Fund flows have favored bonds all year long, and the retail stock investor is still, by and large, on the sidelines.

For our part, we can understand the sentiment shift. However, we still have our share of well-documented concerns about the US economy, foremost of which is the effect of higher rates on the economic recovery. In our December 8 market commentary, we discussed the possible reasons for the recent sell-off in Treasury bonds. To quickly summarize, we suggested that the sell-off could be related to 1) a fear of inflation, given the massive amount of monetary stimulus; 2) the expectation for stronger economic growth ahead; or 3) worries that the US government has become a greater credit risk, given the effect of continued monetary and fiscal stimulus on budget deficits. But regardless of the cause of higher interest rates, a continued rise in rates represents an underappreciated risk in an environment of near-unanimous optimism.

The common rebuttal to the risk of higher interest rates has been that “interest rates are still low by historical standards”. However, it is not the level of interest rates but the direction that matters. Asset prices that are bought using leverage reset to the level of interest rates. This is especially true of housing prices, which are generally purchased using a high amount of debt. A conventional loan requires a 20% down payment while some FHA loans still only require 3.5% down payments. The rest of the purchase price is paid for using debt. Therefore, the affordability of housing is highly sensitive to the level of interest rates. Said another way, a homeowner able to afford a $2,500 monthly mortgage payment can afford more house when interest rates are 4% than he can when they’re 8%.

Consider the effect of a 1% increase in mortgage rates. (Incidentally, the yield on the 10-year Treasury is up almost exactly 1% since the low on October 7). If I were considering the purchase of a $300,000 home using a 20% down payment and a $240,000 mortgage, my monthly payment would rise $147 per month, or $1,764 per year, or 12%, if my mortgage rate were to rise from 4.5% to 5.5%. In other words, the affordability of that home would decline by 12% with a 1% rise in the mortgage rate.

Given the importance we place on a recovering housing market, we continue to worry about continued housing price declines and their effect on consumer confidence and spending. And, needless to say, higher interest rates can have negative implications across the economy – not just in housing. Therefore, the wildcard for 2011, in our view, is interest rates. Our December 8 market commentary was entitled “Has the Fed Lost Control of the Bond Markets?”. If this is indeed the case and interest rates continue to rise, we fear the negative ramifications for the economy and stock prices could be significant. Keep this risk in mind when listening to the rosy forecasts for 2011.

Next week we will send out our Top Ten stocks for ‘11. If you have friends or colleagues who might like to receive our free weekly market commentary, please send us their email addresses and we will include them. (We keep our lists completely private and do not litter with solicitations.) I’d very much appreciate your help in increasing our following.

Next week “Farr and Farrell” will be appearing everyday on CNBC around 2:30 to fill in for the vacationing Jim Cramer for “Stop Trading.” Vince and I will try to keep it lively!

Merry Christmas!