Michael Lewitt, the manager of the Third Friday Total Return Fund Lp. who has warned that stocks are in a bubble, said investors need to take heed of the Federal Reserve’s intentions to raise interest rates two more times this year.
“Easy monetary policy was a major tailwind for equities since the crisis; rising rates are now going to be a headwind though it will take Federal funds rate of over 2 percent to worry equity investors,” he said in the April 1 edition of his Credit Strategist newsletter. “While the nominal level of rates is still low, the increase in relative terms from zero is significant.” The Fed funds rate is about 1 percent after last month’s hike of 0.25 percentage point.
The Fed last month raised interest rates for the third time in the past 10 years with the prospect that President Donald Trump would push for a fiscal plan to stimulate stronger economic growth. The central bank has held rates near record lows since 2008, when the global economy suffered its worst decline since the Great Depression as a U.S. housing bubble collapsed.
Higher rates not only lure some investors into bonds that pay a better risk-free rate of return, but they also can hurt the profitabilty of companies that payer higher costs on their debts. Both pressures are negative for stocks.
“With unemployment and inflation hitting the Fed’s targets a long time ago (that is, hitting the targets as the Fed interprets them, not as they actually exist in the real world) and with the stock market still trading at extremely rich levels, Yellen & Co. are out of excuses for keeping rates low,” Lewitt said of Janet Yellen, chair of the central bank.
The Fed’s prolonged period of loose credit policies has make stocks too expensive compared with company profitability, Lewitt said. He cites data that show the S&P 500 stock index trading at 22 times trailing 12-month earnings according to generally accepted accounting principles, not far the 24 times multiple of the dot-com bubble in the 1990s.
The retail, energy and financial industries are losing steam after getting a lift from Trump’s election on a business-friendly campaign platform.
“These are not the building blocks for another leg up in the market, but maybe computers and exchange-traded funds will carry the day and launch the indices to new highs until even they can no longer deny economic and company fundamentals,” he said.
Mom-and-pop investors have been putting record amounts of money into ETFs and passive trading strategies that buy stocks of entire industry groups or regions as a way of diversifying risk.
But Lewitt warns against blindly buying the market, especially if when broader indices are dependent upon a handful of the same stocks.
“At these levels, investors need to seek out those rare stocks that offer value, not indices that odder nothing but herd thinking and momentum,” he said. “Momentum can reverse very easily and one day investors are going to wake up and realize that the emperor is wearing no clothes.”
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