Contrarian Investing and the Direction of Interest Rates – The Guide Rock Capital Market Commentary – FT046

Contrarians probably are waiting for the other shoe – or, in this case, U.S. stock markets – to drop.

If you’re not familiar with contrarian investing, the theory goes something like this: Consensus opinion is often wrong. When the majority of investors have a bullish outlook and believe stocks are going to move higher, the chances are stock values will drop. Likewise, when the majority has a bearish outlook and believes stocks are going to move lower, the chances are stock values will rise.

Why would Contrarians expect markets to head south? One reason is bullish sentiment is high. On October 23, the American Association of Individual Investors’ Investor Sentiment Survey, which measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months, shows 49.2 percent are bullish and just 17.6 percent are bearish (the rest are neutral). The long-term averages for bullish and bearish sentiment are 39 percent and 30.5 percent, respectively.

Contrarians also are eyeballing the fact that stock markets in the United States have run up for 519 sessions without as much as a 10 percent correction, according to Barron’s. That means markets have weathered bombs at the Boston marathon, chemical weapons in Syria, monetary policy uncertainty, U.S. government shutdown, and Miley Cyrus’ VMA performance. Of course, 519 sessions is not the longest winning streak ever, not even close. In fact, if we assume about 250 trading sessions in a year, then the current rally would have to last until about 2018 to match the record (1,767 sessions) set between October 1990 and October 1997.

Investors aren’t the only bullish faction. Money managers who participated in Barron’s latest big money poll also seem to have adopted Alfred E. Neuman’s motto: What, me worry? Their outlook seems to focus on the Fed’s loose monetary policy. According to Barron’s, “Four of five money managers in our big-money poll expect stocks to be the best-performing asset over the next year, even as 71 percent see U.S. shares as already fairly valued. Thanks to unending central bank support, we all expect above-par stock returns from sub-par economic growth.”

So, what’s going to happen? Only time will tell.

Notes: S&P 500, Gold, DJ-UBS Commodity Index returns exclude reinvested dividends (gold does not pay a dividend) and the three-, five-, and 10-year returns are annualized; the DJ Equity All REIT TR Index does include reinvested dividends and the three-, five-, and 10-year returns are annualized; and the 10-year Treasury Note is simply the yield at the close of the day on each of the historical time periods.

Sources: Yahoo! Finance, Barron’s, djindexes.com, London Bullion Market Association.

Past performance is no guarantee of future results. Indices are unmanaged and cannot be invested into directly. N/A means not applicable.

WHERE ARE INTEREST RATES HEADED? According to the Federal Reserve, economists assume interest rates will move toward equilibrium or a ‘natural’ real rate of interest that takes into account inflation over the long term.

The idea of a natural rate of interest was first introduced by Swedish economist Knut Wicksell.  Recognized as an economist’s economist in the late 1800s and early 1900s, Wicksell is known for his macroeconomic text Interest and Prices which noted the difference between the real rate of return on capital (aka: the natural rate of interest) and the market rate of interest (aka: the rate borrowers pay). According to The Economist:

“If the financial rate is below the natural rate, businesses can reap unlimited profits by borrowing as much as they can and plowing it into high-returning projects. Eventually, though, all that additional spending pushes up prices, money and credit, and, eventually, financial interest rates.

Wicksell saw financial rates as those set by banks competing to make loans. That job is now performed by central banks. They still think in Wicksellian terms: the natural rate prevails when the economy is at full employment. Set the policy rate above the natural rate and the economy tips into depression. Set it below, and inflation results – or, some worry, speculative credit booms.”

So, where are interest rates headed? Apparently, they’re going to move higher. According to the Federal Reserve’s September 2013 economic projections, the federal funds rate (the rate at which banks lend to each other overnight) is expected to reach 2 percent by the end of 2016. Currently, it is at 0.25 percent. (The Fed also expects the United States will be close to full employment at that time with the unemployment rate nearing its long-term average of 5.2 to 5.8 percent.)

Weekly Focus – Think About It

“It has always seemed strange to me… the things we admire in men, kindness and generosity, openness, honesty, understanding and feeling, are the concomitants of failure in our system. And those traits we detest, sharpness, greed, acquisitiveness, meanness, egotism and self-interest, are the traits of success. And, while men admire the quality of the first, they love the produce of the second.”

—John Steinbeck, Pulitzer and Nobel Prize-winning American author

Best regards,

ANDREW HUNT CFP®
President of Guide Rock Capital Management, Inc.

402.938.6016
1001 Gallup Drive
Omaha, NE 68102
Communication | Woo | Achiever | Ideation | Relator

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* This newsletter was prepared by Peak Advisor Alliance. Peak Advisor Alliance is not affiliated with the named broker/dealer.

* The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general.

* The 10-year Treasury Note represents debt owed by the United States Treasury to the public. Since the U.S. Government is seen as a risk-free borrower, investors use the 10-year Treasury Note as a benchmark for the long-term bond market.

* Gold represents the London afternoon gold price fix as reported by the London Bullion Market Association.

* The DJ Commodity Index is designed to be a highly liquid and diversified benchmark for the commodity futures market. The Index is composed of futures contracts on 19 physical commodities and was launched on July 14, 1998.

* The DJ Equity All REIT TR Index measures the total return performance of the equity subcategory of the Real Estate Investment Trust (REIT) industry as calculated by Dow Jones.

* Yahoo! Finance is the source for any reference to the performance of an index between two specific periods.

* Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance.

* Past performance does not guarantee future results.

* You cannot invest directly in an index.

* Consult your financial professional before making any investment decision.

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