Can Low-Interest Rates Bail Us Out?


J.P. Morgan ushered in the creation of U.S. Steel over 100 years ago, melding together disparate elements for balance and viability. The textbooks on money and banking considered his work pure genius. But, times do change. Who cares about U.S. Steel today? Nobody cares. Guys in t-shirts hog center stage, starting with Jeff Bezos and Zuck.

When I doubled back into financial history, early-postwar decades, I was surprised to see how long low interest rates prevailed. By now, everyone knows the reciprocal of minimal rates is a price-earnings ratio in the high-teens, what we’re enjoying today.

The Street, early fifties, was a small village of custom-tailored anachronisms. Bonds were preferred over stocks which were considered vulgar upstarts that yielded more than bonds. The horrors of 1929 lurked in all the players who had relied on the mumbo-jumbo of market technicians.

Even late fifties, before technology took off with the advent of the transistor, it was a blue-chip world comprised of starched-white collar corporations like General Electric, General Motors, Dow Chemical, U.S. Steel, American Telephone and Metropolitan Life Insurance. Everyone at Harvard Business School yearned for placement there. Few if any Jewish trainees were welcomed.

What I remember about banks, early fifties, was their open-floor construct of aligned, plain-wooden desks, neatly kept. The noise level was funereally low. Bank executives talked more about opening new branches in the suburbs rather than innovative lending to the Third World. Mortgages were written at 4% in a 70/30 ratio. I remember 7%, but now the going rate is like 3.5%.

Early sixties, FRB chairman McChesney Martin put up margin requirements to 90%. I was borrowing funds at 7% from money brokers to play in the convertibles game, uncovered by margin regulation. You put up 10 points and were marked to market, daily. Absent borrowed funds my $10,000 stake would have taken me nowhere.

Contrast all this with my 1987 experience when Black Monday shook the Street. I was up to my ass in a hostile tender bid for Caesars World. No money manager as yet did hostile tenders. Maybe Carl Icahn was lurking in the bushes, too. I was paying 8% for a traunch of preferred stock and a standby commitment for a billion in bank debt at 7.5%.

I remember standing next to Larry Tisch at Jerry Tsai’s wedding engagement party for his Street buddies. Larry was discussing the market’s risk premium, but I thought of my four-million share position in Caesars, cascading down from high-twenties to 10 bucks on Black Monday. Tisch then was a monosyllabic-value player who nodded his head. I wrote off $20 million in fees and expenses and went back to managing money, ridding myself of grandiosity.

My God! The late eighties and late nineties were a sham. When you adjust for tons of options issuance, outrageous write-offs and crazy (still crazy) opportunistic-actuarial assumptions on corporate pension funds, earnings grew at their historical rate of 4%, not the 8% to 9% most pundits projected.

Investors with a sense of history know the rate of return on equities can be negative, even for a decade. The historic rate of return on stocks comes in at 6.1% with an equity risk premium of 2.4%. The inflation-adjusted rate of return on 10-year Treasuries is 3.7%. Real returns are systematically lower than earnings yields throughout our financial history. Calling the market cheap when 10-year Treasuries yield below 2% and AAA corporates rest at 3.5% is a mistake. First sign of economic resurgence can tighten the spread practically overnight. The bond market turns on a dime just as fast as the Big Board. Count on it.

As a fully invested skeptic, I hope my sense of valuation and contrarianism bail me out. I keep my sixties pocket slide rule on my desk, a reminder that numbers finally do govern, not words. Judy’s prancing threesome on the Yellow Brick Road got it right:  You need a heart, brain and courage. Now as then, violate conventional valuation discipline? Chances are you’ll get a dirty car wash with little or no wherewithal for a comeback.

Sooo… with some relief and nostalgia I went back into the early fifties when speculation was disdained, a dirty word. Corporations lived within their cash flow numbers as to capital spending, dividend payout ratios and debt-equity constructs in their balance sheets. There was no Occidental Petroleum leveraged ridiculously to buy another energy property for the sake of getting bigger.

I found that the average stock in the S&P 500 Index sold at 16 times earnings in a normal setting of economic growth. Corporate profit margins held up in an environment of moderate wage growth. AAA bonds traded as low as 25 basis points above 10-year Treasuries, a great borrowing bargain. When inflation runs around 3%, stocks invariably sell above 15 times earnings. Today, our FRB yearns for 2% inflation. Bureaucratic stupidity!

Going back as far as 1930, I found p/e ratios ranging from 10 to 12 times earnings just so long as long-term Treasury yields ranged between zero and 1%. Wages in 1950 got as low as 61% of GDP, but spiked early in 1982 to 69% of GDP. This wage-inflation construct you’d lay at the feet of Ford Motor and General Motors. It provoked Paul Volcker to raise interest rates as high as 15% to rid the country of its inflationary expectations. The market sold down to 10 times earnings while Volcker got his job done.

During the 2008-2009 financial meltdown Fed Funds were held below 1% through 2015. The market’s price-earnings ratio today of 18 times forward 12-month earnings projections was never sustainable because business cycles intervened. The range for household ownership of equities, early fifties, ran as low as 13% of financial assets, but peaked as high as 29% before the horrendous recession of 1973-1974. Such a pattern of amplitude was repeated from the tech bubble of 2000 to the 2008-2009 disaster.

The market sell-down to 800 in 2002 and again near 700 in 2009 was symmetrical in the sense that the wipe-outs started from 1,600. Same goes in 1987’s Black Monday and Volcker’s hand-carved 1982 recession.

Today, the S&P 500 sells at 18 times earnings, two times book value and yields near 2%. In a panic selloff for whatever reason – geopolitical, business cycle compression or even rampant inflation, the market could sell down to book value and yield over 4%. We are talking abstractly about a 1,400 level from the present 3,100 number. Nobody, of course, sees this coming. Bears see maybe a correction of 10% to 20% in amplitude, mainly business-cycle related. Earnings top out and decline 10% to 20%.

As a player, I’m not smart enough to see all this around the corner. I own bank stocks because I think the p/e discount to the market is too steep. But, in a recession the group can sell at 10 times depressed earnings, not 13 times growing earnings.

I haven’t owned starched-white collar companies like Alcoa, U.S. Steel, DowDuPont, even Exxon Mobil for 50 years. The market value of U.S. Steel under near $3 billion with Apple and Microsoft ticking over a trillion. General Motors needed a bailout in 2009. Even today, it sells at six times earnings. Nobody cares because earnings could drop to two bucks in a sluggish car year.

My e-commerce stock is Alibaba, not Amazon because I can model Alibaba, but not Amazon. Facebook and Alphabet sell at acceptable levels of Ebitda to enterprise value and to their operating-earnings multiples. My implicit bet is recession ain’t around the corner.

I won’t turn my back on AT&T, a show me stock. They need to hold their own in the entertainment sector. HBO is a viable competitor. The dividend-payout ratio is conservative and yields comfortably over 5%. You can’t just own internet and e-commerce paper. Such stocks are at least 1.5 times as volatile as the S&P 500 Index. Consider, Nasdaq, adjusted for volume exceeds Big Board valuation.

Recognition that the game has changed markedly over 50 years is your starting point in understanding what’s out there that could bury you. I worry about a grassroots panic, considering trillions amassed in passive ETFs and index funds. Any stock that disappoints today is marked down 10% or more, overnight. All this suggests we are in the midst of a frothy market. History suggests the market never sells at 18 times earnings for an extended stretch. Reality intervenes.

Sosnoff and / or his managed accounts own: AT&T, Ford Motor bonds, Microsoft, Alibaba and Alphabet.

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