By Rick Ferri
The old adage, “Don’t fight the Fed” is good advice for investors this year. The stock market is likely to continue higher in 2013 thanks to the Federal Reserve policies. Their decision to keep interest rates below the inflation rate is driving investors back to stocks and other growth assets out of necessity. This trend will likely continue for the foreseeable future.
We are in a period of “financial repression.” This sounds like an ominous state of affairs, but it’s actually a combination of economic stimulus and a stealth tax at the same time. The purpose is to encourage investment and, at the same time, inflate away the deficit.
Financial repression occurs when Central Bank policy drives interest rates well below the inflation rate. This makes it affordable for young people to buy homes and for businesses to borrow money for growth. It also reduces the deficit because the government can borrow $1 today and pay back less than $1 in the years ahead, including interest.
Inflation is a government created phenomenon. It is controlled in part by the amount of dollars printed by the Treasury and put into circulation by the Federal Reserve. The more dollars in circulation, the higher inflation is expected to go. The Consumer Price Index (CPI), a broad measure of consumer inflation, is running about 1.7 percent per year according to the Bureau of Labor Statistics.
In contrast, 2-year Treasury bonds are yielding 0.25 percent and 3-month Treasury Bills are yielding only 0.07 percent. Every dollar invested in these securities yields far less than the inflation rate. Investors are losing about $1.5 per year in real dollars for every $100 invested and this is before income taxes are paid on the interest.
A by-product of financial repression is higher valuation for stocks, real estate and other growth assets. Investors cannot afford to watch their wealth wither away in low-returning money market funds and short-term bonds. They must try to earn a higher return just to stay even. This means a shift to riskier assets. It’s one reason global stocks were strong in 2012 and why I expect the rally to continue in 2013.
Higher valuations do not mean stock prices are heading into a bubble like in 1999. The rally began in 2009 with very low valuations and current prices are not out of a normal valuation range. The stock market could tag on another 20 percent before valuations become a concern.
In addition, there are economic benefits and deficit reduction benefits to higher stock prices. As people earn more in stocks, they tend to feel wealthier and spend more. In turn, this increases economic growth, lowers unemployment, increases revenue to the government, raises corporate earnings and justifies higher stock prices.
Fed policy will keep interest rates very low and this will continue to drive stock prices higher. I’m optimistic about the market in 2013.
Richard (Rick) A. Ferri, CFA is the founder of Portfolio Solutions, the low-fee investment management firm he founded in 1999, which currently manages more than $1 billion in assets. He is the author of six investing-related books, and shares his insights as a frequent news commentator, Forbes columnist, media contributor and public speaker. Rick holds a Master of Science degree in finance from Michigan’s Walsh College, where he has served as an adjunct professor. Prior to entering the financial industry, Rick served as a U.S. Marine Corps officer and fighter pilot before retiring from the reserves in 2001 with twenty years of service.