2013 Lane Reports

The Federal Reserve, Interest Rates, and Your Income Requirements

The Lane Report, March 2013
Friday, March 1, 2013 10:00 am
by Kenneth N. Green, CPA

Today we find ourselves in what arguably is the most difficult environment for income investors in our nation's history. Yields on both stocks and bonds have been on the decline for the past three decades. Add to this the fact that as the baby boom generation now approaching retirement is swelling the ranks of income seeking investors. In competing with one another, this population is driving up demand and hence driving down yields.

Meanwhile, the Federal Reserve is trying to meet its multiple mandate of promoting economic growth while maintaining maximum employment and price stability.  I do not envy Ben Bernanke.

How is the Federal Reserve navigating the current environment and what are the implications for investors seeking income? 

Under the program known as Large Scale Asset Purchases, commonly referred to as quantitative easing, the size of the Fed's balance sheet has tripled in the past four years. The effort here has been to keep longer term interest rates not directly controlled by the Fed lower than they otherwise would be. This has led to heated arguments among economists as to the potential for a large increase in inflation in the not too distant future. Is the significant increase in the money supply, narrowly defined (M1), destined to result in high inflation? Actually, the record of the past few decades would indicate not as there has not been a high degree of correlation between the two.

The increase in the size of the Fed's balance sheet worries those who believe there will be a rapid rise in the money supply. Actually, this has not happened as most of the asset purchases engineered by the Fed have sat idle as excess reserves as banks have merely re-deposited these funds at the Fed. Although this sounds confusing, it is the result of banks not having enough good lending opportunities for their new funds so they deposit them at the Fed and earn a token rate of interest. This has helped banks improve their capital cushions. The result has been that the broader measure of money growth, M2, has been rising approximately 6% per year for the past four years. This rate is within the bounds of a non-inflationary historical growth rate.

This does not mean inflation will remain tame forever. It has remained low so far for several reasons: consumers are saving more and have been paying down debt, banks have not been lending as aggressively as in the past, and wages have not been keeping up with inflation. The question becomes that as these conditions begin to change, does the Fed have the tools to contain inflation? We believe that the Fed does have the tools. Will the Fed have the discipline to use these tools when the time comes? Inevitably there will be political pressure not to apply the brakes in order to help keep employment and GDP rising. Several economists worry that the Fed will slide the current 2% inflation target higher. There is no way to predict this. Nonetheless, the Fed has established excellent inflation fighting credentials over the past generation and we believe it would loathe losing this.

For investors simultaneously worried about maintaining a safe source of income and their purchasing power, the current environment presents quite a conundrum. The yield on the 10-Year Treasury note today is 1.90% while the yield on the S & P 500 stock index is 2.17%! It has been more than a few decades since stocks provided a higher yield than Treasury notes. A bond investor can invest in somewhat lower quality bonds which entail greater risk or even low quality bonds known as “junk” bonds which have about the same risk as stocks. Such an investor faces the potential for both increased volatility and capital depreciation. There is no easy answer to this dilemma and there never will be. The entire matter comes down to risk vs. reward. Common stocks currently offer higher yields but entail obvious risks. Many investors still have not gotten over the shock of the 2008 – 2009 market meltdown the bottom of which will have been reached four years ago come March 9. But in choosing equities, which equities should an erstwhile conservative investor choose? For several years I've been a fervent advocate in this space for companies that not only offer dividends but have a history of increasing them for five, ten, or an even greater number of years. Such stocks have provided both growing income streams to their investors as well as higher total returns than those stocks that do not grow their payouts and those that do not pay dividends at all.

S&P 500 total returns – 12/31/87 – 6/30/12

Dividend Growers – 8.91%         
Dividend payers with no change in dividend – 5.60%    
Non dividend payers – 1.27%                    
Source:  Ned Davis Research

This evaluation precludes investing in the highest yielding stocks. We prefer those stocks that have good yields and the wherewithal to keep increasing their payouts. Investors who bought financial stocks in 2007 for their good yields learned this lesson the hard way.

Where does one find stocks that have sound balance sheets, decent yields, and growing payouts? At this time, several European stocks that have excellent dividend histories are selling at attractive valuations compared to their American counterparts. Locally, the health care, consumer staples, and industrial sectors have always had many companies that are suitable for income investors. And, most recently, large companies in the technology sector have initiated and grown their payouts.

The quest for income is not simply about reaching for the highest yield. But, those companies that can afford to prudently increase their dividends every year have shown themselves capable of surviving all of the economic storms that the world has had.

For assistance with your investments, we invite you to reach out to Marc Lane at mlane@MarcJLane.com or 312/372-1040, locally (800/372-1040, nationally).

Kenneth N. Green is Senior Vice President and Director of Investment Research for Marc J. Lane & Company and Marc J. Lane Investment Management, Inc. Mr. Green is a graduate of the University of Michigan (M.B.A.) and the University of Illinois at Urbana (B.S.). Mr. Green is also a Certified Public Accountant (CPA).

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