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We don’t have to predict rates to adjust our expectations

Rates are near all-time lows across the civilized world. Everyone has an opinion about what that means for stocks – some say rates must soon start marching back up to 1982 levels, thereby dragging down multiples. Others say that we don’t have to worry about current high valuations since we’re in a low-rate era, or even that our idea of fair-value CAPE and price:sales ratios are outdated. A look at rate history and what drives interest rates should dispel any illusion that rates are predictable or that we can use them to forecast stock prices.

To predict that our aging, indebted, low-growth economy will produce double-digit rates is to ignore the experience of nations like Japan and Switzerland. In fact, the formative years of the baby boom generation were the only time in US history that rates exceeded 8%. There may very well be a generational cycle at play, but a look at history shows that it does not have any kind of regularity in period or magnitude. Nor do we have a long enough time series for confidence in any pattern, as modern capitalism has only prevailed for a few generations.

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The interest rate, or time preference, is a social phenomenon tied to social mood, risk-tolerance, and crime levels. Time preference increases as people age – the young have a higher implied discount rate. The rebellious early adulthood of the boomers upset the social fabric of the western world, perhaps helping to drive what may have been a normal secular peak of 6-8% into the teens. Also note that rates are tied to real wage and GDP growth, which was very strong 30-40 years ago despite inflation. And by the way, the last bottom in the 1940s coincided with double digit wartime inflation. Wrap your head around that. The rate cycle is an unfathomable topic, and if we can’t even understand the past we shouldn’t try to predict the future.

I am not comfortable making predictions about interest rates, or anything else in the markets. Any commentator who does so with confidence is foolish or employing a marketing trick. While we shouldn’t predict, we can still adjust our expectations. Rates are low, equity multiples are high, and thus expected returns are lower than a generation ago when we had the opposite.

The only sensible solution is the same as at any other time in history: make a plan that you can follow your whole investing career, one that does not require predictions, only that you stay the course through the ever-shifting “what ifs” of market chatter.
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