Winners and Losers From Two More Years of a Zero Interest Rate Policy

I espouse a strategy of broad diversification, with the corollary that I never double down in a position. That’s how I keep the emotion out of my portfolio strategy and can therefore be ready to walk out if a company does falter.

— Roger Conrad, Big Yield Hunting

The stock market is giving me motion sickness. The Dow Jones Industrials were down 630 points on Monday after Standard and Poor’s downgraded U.S. debt, then shot up 430 points on Tuesday on the Federal Reserve’s announcement that it would keep short-term interest rates at zero for another two years (i.e., mid-2013), and now has fallen back 520 points today on news that the credit ratings of French banks – and perhaps France itself — may be the next to be downgraded.

My prediction that stock market volatility would be going up has, unfortunately, been proven true.

Frankly, I was surprised that the market reacted so positively to the Federal Reserve’s statement yesterday. After all, the Fed made the following unpleasant statements:

  • U.S. economic growth has been “slower than expected” and “only some” of the weakness can be blamed on temporary factors such as automobile supply-chain disruptions from the Japanese nuclear crisis and spiking oil prices caused by Middle East political instability.
  • “Deterioration” has occurred in employment, consumer spending, and construction.
  • “Downside risks to the economic outlook have increased.”

What’s bullish about any of that? Nothing, but what was bullish for financial asset prices was the Fed’s commitment to keep short-term interest rates at zero until mid-2013. This statement was much more specific than the typical language in its policy statements since March 2009 committing to keep rates at zero for “an extended period.” Market pundits have interpreted “extended period” to mean that the Fed won’t raise rates for at least six months. So an explicit two-year commitment is a significant change. Keep in mind that the Fed didn’t guarantee that it would keep rates at zero for two years. Rather, it left itself some wiggle room by using the phrases “currently anticipates” and “likely to warrant.”

Assuming, however, that short-term rates are kept at zero for two years, this begs the question: which companies benefit from rock-bottom short rates and which stocks are hurt? The short answer is that borrowers win and lenders lose. Below is my list of the stock market winners and losers:

Winners

Financials. Commercial banks are both borrowers and lenders, so the key to whether they are winners is the spread between what the rate at which they borrow money and the rate at which they borrow money. Borrowing at zero, however, sure helps ensure that the spread is positive. Individuals and businesses can’t borrow at zero and that’s why banks can basically mint their own money right now. So why haven’t bank stocks performed better? Many still are exposed to the home mortgage market, which remains depressed. This housing exposure can trump any benefit these banks get from low interest rates, so tread carefully!

Investment banks also benefit from low rates because their corporate clients are more likely to issue new debt — and pay underwriting fees — when rates are low. Bruce Berkowitz, manager of the Fairholme Fund (FAIRX), is a big bull on financial stocks. Examples:

  • Wells Fargo (NYSE: WFC)
  • JP Morgan (NYSE: JPM)
  • Goldman Sachs (NYSE: GS)
  • Morgan Stanley (NSYE: MS)

Consumer Durables. Big-ticket items like houses, automobiles, and refrigerators are typically sold to consumers on installment plans where the monthly payments depends on interest rates. The lower the interest rate, the more affordable the consumer loan and the more consumers that will end up buying these products. Examples:

  • Toll Brothers (NYSE: TOL)
  • Ford Motor (NYSE: F)
  • Whirlpool (NYSE: WHR)

Dividend-Paying Stocks. Low rates mean “cash is trash” and investors who want to earn money cannot rely on bank savings accounts or CDs to generate the annual income they need. Consequently, these income investors bid up the stock prices of high dividend-paying stocks. Best bets include energy-based master limited partnerships (MLPs), drug stocks, Australian and Canadian stocks, junk bond ETFs, and real estate investment trusts (REITs). Examples:

  • Alerian MLP Index Fund (NYSE: AMJ)
  • WisdomTree Australia Dividend (NYSE: AUSE)
  • Eli Lilly (NYSE: LLY)
  • SPDR High-Yield Bond Fund (NYSE: JNK)
  • Annaly Capital Management (NYSE: NLY)

Losers

Insurance Companies. Most insurance companies make very little profit on the premiums they receive for writing insurance policies. The money paid out in claims down the road is pretty close in amount to the money they receive up front. Still, insurance companies are very profitable because of the time discrepancy between the two. The time between receiving insurance premiums and paying out claims is called the “float.” This float is, in essence, an interest-free loan that can be used to make investments.

Consequently, insurance company profits depend on earning a good return from investments. State regulations require that insurance companies invest in safe, low-volatility securities that can be liquidated at par value when needed to pay out claims. In other words, most of an insurance company’s investments must be in U.S. Treasuries and the like. Low interest rates mean low returns from investing in U.S. Treasuries and lower insurance company profits. Examples:

Online Brokers. Similar to insurers, online brokers make a lot of their profits not from dirt-cheap trading commissions, but from margin loans. Lower rates mean less money earned on these loans. Examples:

Big Yield Hunting Has an “Income Plus” Investment Philosophy

The above-named stocks are just examples, not recommendations. For the best double-digit yields, check out Big Yield Hunting, the high-yield investment service from Roger Conrad and David Dittman. Roger and David are humble value investors who thoroughly vet a stock before recommending it to subscribers. They take an “income plus” approach to their recommendations. High yield alone is not enough; they demand high yield “plus” a healthy and growing business:

High yields without strong businesses behind them will be at perpetual risk of devastating dividend cuts. And they have no chance of growing either, so they’re guaranteed losers if inflation emerges.

In contrast, only growing and healthy companies will continue to pay their distributions. If we see more inflation, growth is our best chance of keeping pace. Adopting an “income-plus” strategy won’t save your portfolio from all volatility if credit or inflation conditions worsen. But it remains the best approach.

An “income plus” investment standard disqualifies many high-yield companies from Roger and David’s consideration. Big Yield Hunting has recommended Canadian income trusts, telecommunications companies, master limited partnerships (MLP), and a fascinating stock/bond hybrid security. All of these top-notch stocks sport very high yields that are stable and sustainable.

Give Big Yield Hunting a try today!