Insights & Advice

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Easy money equals higher markets.

There was one axiom that investors could almost always rely on: as interest rates decline, stocks move higher. But things got squirrely last year and with the financial system on the verge of collapse; the Federal Reserve forced interest rates down to historic low levels in an effort to provide liquidity to banks and other businesses. Stocks reacted by going higher. Now interest rates are still at historic lows and from every indication, the Fed is going to maintain these levels into 2010. That should be good for stocks.

It doesn’t take a rocket scientist to figure it out. And if you think about it, it makes total sense. Most investors’ behavior alternates between fear and greed. In this case, many fear that the recovery will be too feeble, that when the government takes away the dinner plate in the form of easy money, the economy will stumble and die.

So if you are a bond holder, your worse fear is that companies may default on their debt if the economy rolls over. To adjust for that extra risk, in normal times, buyers would demand higher interest rates to compensate. But times are not normal. Because the recovery is so fragile, the Federal Reserve is flooding the markets with cheap money. So interest rates are going down, not up, the opposite effect that bond buyers would expect.

This is where greed plays a part. The Fed has pushed interest rates so low that money market rates and other ‘safe’ debt instruments are yielding a pittance. At the same time, even the most fearful investor has been watching the stock market go up and up and up. The Fed is betting that if they keep rates low enough, greed will overcome fear and investors will begin to put their money to work. Now the Fed doesn’t care where you put that money you’re hoarding. You can go buy a house, a car, a company, stocks or whatever you think is going to earn you better than the half percent your cash is yielding right now. For my wife and me, that’s buying a house in Pittsfield.

For companies, such as banks, there are other avenues. They can borrow at 1% or less and loan that money to me at 5% for a mortgage or to the car dealership down the street or any number of businesses out there. If you are IBM or Google, you can borrow at almost the same rate and buy back stock or take over another company, provided you believe that the appreciation in the shares you’re buying will be greater than what you can get by staying in cash.

I talked to a general contractor today who does a lot of work in the Williamstown, MA area and has also done quite a bit of business in Millerton, N.Y. as well.

“The people with $30-40 million to throw around weren’t doing it until recently. They’ve made a little in the markets and are just now starting to spend,” he said.

“But what about us common folk?” I asked.

“Take a working couple, say two college professors at Williams College, with secure jobs. Rates are low so they are borrowing and the banks are willing to lend to that kind of profile. They’re looking at home improvements; others are buying property. The point is they are spending.”

That is my point as well. As last year’s losses fade, the choice between staying in cash or doing something with it that generates a return, whether psychological or otherwise, is becoming abundantly clear. The Fed’s intent is to lure you back into spending and/or investing and they have not been shy in telegraphing that to investors. The stock market appears to be a no brainer under those circumstances as long as the easy money policy lasts. Of course, it just may bring on yet another bubble, but I think the Fed’s attitude is that they will worry about that when we get there. Sound familiar?

Posted in A Few Dollars More, At the Market